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ELEMENTARY PRINCIPLES OF ECONOMICS 



•Th< 



THE MACMILLAN COMPANY 

NEW YORK • BOSTON • CHICAGO 
SAN FRANCISCO 

MACMILLAN & CO., Limited 

LONDON • BOMBAY • CALCUTTA 
MELBOURNE 

THE MACMILLAN CO. OF CANADA, Ltd. 

TORONTO 



ELEMENTARY PRINCIPLES 



OF 



ECONOMICS 



BY 
IRVING FISHER 

PROFESSOR OF POLITICAL ECONOMY 
YALE UNIVERSITY 



Ncfo ffork 

THE MACMILLAN COMPANY 

1911 

All rights reurvtd 






Copyright, 1911, 
By THE MACMILLAN COMPANY. 



Set up and electrotyped. Published September, 1911. 






Nortoootr Jltcss 

J. S, Cashing Co. — Berwick & Smith Co. 

Norwood, Mass., U.S.A. 



©CI.A297199 






THE MEMORY OF MY FRIEND 

AND COLLEAGUE 

PROFESSOR LESTER W. ZARTMAN 



PREFACE 

For Teachers 

The words " Elementary Principles " in the title of this 
book indicate the limits of its scope ; the book is intended 
to be elementary, not advanced, and to be concerned with 
economic principles, not their applications. 

First, being elementary, it does not attempt to unravel 
the most difficult tangles of economic theory or to intro- 
duce controversial matter. For such studies it should be 
succeeded by more extensive treatises (e.g., my own : Nature 
of Capital and Income, Mathematical Investigations in the 
T/ieory of Value arid Prices, Purchasing Power of Money, 
and Rate of Interest, which follow out the same general 
system of thought and exposition as adopted in this book). 

Secondly, being devoted to principles, the book is con- 
fined to that part or aspect of economics which is now 
coming to be recognized as capable of scientific treatment 
in the sense, for instance, in which that term may be ap- 
plied to physics or biology. The fundamental distinction 
of a scientific principle is that it is always conditional ; its 
form of statement is : If A is true, then B is true. Science 
is primarily concerned with the formulation of such princi- 
ples or laws. The aim of this book is to formulate some 
of the fundamental laws relating to economics. 

The method and order of treatment are not altogether 
traditional. The time-honored order of topics — produc- 
tion, exchange, distribution, consumption — has been found 
impracticable. Such an order was probably originally in- 
tended to parallel the natural course of events from the 



viii PREFACE 

production of an article to its consumption ; but to-day 
this order of topics scarcely retains any traces of such a 
sequence. "Distribution," for instance, has long ceased 
to be a description of the processes by which food, cloth- 
ing, and other goods are distributed after being produced 
and prior to being consumed, and has become simply a 
study of the determination of rent, interest, and other 
market magnitudes. It is not, therefore, surprising that 
many other textbooks on economics have also broken away 
from this unfortunate order of topics. 

Of the many possible methods of writing economic text- 
books, there are three which follow well-denned, though 
widely different, orders of topics. These are the "his- 
torical," the " logical," and the " pedagogical." The his- 
torical method follows the order provided by economic 
history ; the logical begins with a classification of economics 
in relation to other studies, explains its methodology, 
and then proceeds by means of abstract examples from the 
simplest imaginary case of " Robinson Crusoe economics " 
to the more complex conditions of real life ; the pedagog- 
ical begins with the student's existing experience, theories, 
and prejudices as to economic topics, and proceeds to mold 
them into a correct and self-consistent whole. The order 
of the first method, therefore, is from ancient to modern ; 
that of the second, from simple to complex; and that of 
the third, from familiar to unfamiliar. The third order is 
the one here adopted. That the proper method of study- 
ing geography is to begin with the locality where the pupil 
lives is now well recognized. Without such a beginning 
the effect on the student's mind may be like that betrayed 
by the schoolgirl, who, after a year's study of geography, 
was surprised to learn that her own playground was a part 
of the surface of the earth. In like manner we cannot 
expect to teach economics successfully unless we begin 
with the material already existing in the student's mind. 
Those textbooks which open with a discussion of the rela- 



PREFACE IX 

tions of economics to anthropology, sociology, jurispru- 
dence, natural science, and biology, overlook the fact that 
the beginner in economics is totally unprepared even to 
understand these concepts, much less their relations to one 
another. The same sort of error is made by those text- 
books which begin with a comparative study of the logical 
machinery by which truth is ground out in economics and 
in other sciences. The student's logical faculty must be 
exercised before it can profitably be analyzed. 

This book, therefore, aims to take due account of those 
ideas with which the student's mind is already furnished, 
and to build on and transform these ideas in a manner 
adapted to the mind containing them. This is especially 
needful where the ideas are apt to be fallacious. The eco- 
nomic ideas most familiar to those first approaching the 
study of economics concern money, — personal pocket 
money and bank accounts, household expenses and in- 
come, the fortunes of the rich. Moreover, these ideas are 
largely fallacious. Therefore, the subject of money is 
introduced early in the book and recurred to continually 
as each new branch of the study is unfolded. For the 
same reason considerable attention is given to cash ac- 
counting, and to those fundamental but neglected princi- 
ples of economics which underlie accounting in general. 
Every student at first is a natural "mercantilist," and 
every teacher has to cope eventually with the prejudices 
and misconceptions which result from this fact. Yet no 
textbook has apparently attempted to meet these difficul- 
ties at the point where they are first encountered, which is 
at the beginning. 

It may be worth while to distinguish the pedagogical 
procedure here proposed from that recently advocated 
under the somewhat infelicitous title of the " Inductive 
Method." I refer to the method by which the student is 
at first to be taught economic facts without any formula- 
tion of principles. This proposal seems to assume that the 



X PREFACE 

student's mind is quite a blank to start with, and that it 
is possible on this tabula rasa to inscribe facts without at 
the same time intimating how they are related. The truth 
is, however, that the student's mind is already familiar 
with a great mass of economic facts acquired at home, 
on the street, and from the newspapers. He knows some- 
thing, not only of money and accounts, but of banks, rail- 
ways, retail trade, labor unions, trusts, the stock market, 
speculation, the tariff, poverty, wealth, and innumerable 
other topics. It is equally true that his head is full of 
theories as to the relations of these facts, — the working 
of supply and demand, the nature of money, the operation 
of a protective tariff, etc. The difficulty is that most of 
his theories and many of his supposed facts are false ; and 
before we add to his ill-assorted collection of mental furni- 
ture we must arrange in orderly fashion that which he 
already possesses. Moreover, it is almost impossible to 
impart successfully any considerable mass of disconnected 
facts. If the teacher does not indicate the true connec- 
tions, the student will almost inevitably supply false ones ; 
or else the facts without connections will be also without 
interest. 

These objections to the so-called " inductive method " 
are not, however, intended as militating against the object 
which its advocates strive to attain, viz., to make the stu- 
dent think for himself, nor against the chief means by 
which they actually attain this object, viz., the use of 
original problems. Every teacher can and should illus- 
trate, emphasize, and elaborate every step in the study of 
principles by propounding problems. Sumner's collection 
of problems, or the more recent collections of Taylor or of 
the University of Chicago, may profitably be used to sup- 
plement those which every good teacher will readily invent 
for himself from the suggestions of the text, of current 
newspapers, or of students' questions. 

What has been said will help explain why greater atten- 



PREFACE XI 

tion than usual is here paid to certain themes, such as 
money, bank deposits, accounting, the rate of interest, and 
the personal distribution of wealth ; as well as why less 
attention than usual is paid to certain other themes, such 
as methodology and those obsolete theories like the ''wage 
fund " theory which (unlike some other obsolete theories) 
has probably never formed any part of the student's 
mental stock in trade. 

To some critics the abundant use of curves may seem 
too advanced for an elementary work. But their use is 
now so common in the advanced treatises to which the 
student is, if possible, to be led, that their introduction 
here is but a necessary part of his preparation. The very 
fact that there is at present no elementary book in which 
the nature and use of the graphic method has been made 
clear for the elementary student is a strong argument for 
its adoption. Moreover, I am persuaded that the "diffi- 
culties " in the elementary use of curves are largely imagi- 
nary. Every beginner in economics may be assumed to be 
familiar with latitude and longitude on a map, and perhaps 
also with the temperature charts in the daily paper. It is 
a very easy step from these to curves of supply and de- 
mand, provided they be used with sufficient frequency and 
with sufficient system to take lodgment in the student's 
memory. The student who sees but one diagram in a book 
will find the initial effort of understanding that diagram 
scarcely worth while, — not much more worth while than 
to be taught the use of logarithms without applying them 
to more than one or two practical examples. As a matter 
of fact, there are few things which so facilitate the under- 
standing of economic relations at every stage of economic 
study as the use of diagrams ; and it is believed that, with 
them, the elementary student can proceed both faster and 
further in economic analysis than without them. 

I have taken so much space to justify those features of 
this book which will seem new, because many teachers to 



Xll PREFACE 

whom the first experimental edition was submitted have 
condemned it at sight as unteachable. I am glad to re- 
port, however, that none of the teachers who have actually 
tested the book in classroom have condemned it. On the 
contrary, they have been unanimously enthusiastic over 
its " teachableness," although many of them had begun its 
use with grave misgivings. 

The present (second) experimental edition is a complete 
revision of the first. A third revision is planned for next 
year, which will be the first edition to be actually pub- 
lished. In the preface to that edition I shall hope to make 
adequate acknowledgment of the valuable assistance I 
have and shall have received from numerous friends and 

colleagues. 

IRVING FISHER. 

August, 191 i. 



SUMMARY 



Foundation Stones 
Introduction 
Capital 
Income 
Capital and Income • 

Determination of Prices 
General Prices . 
Particular Prices • 
Rate of Interest . 

Principles of Distribution 
Sources of Income 
Ownership of Income . 



Chapters I— II 
Chapter III 
Chapters IV-V 
Chapters VI-VII 

Chapters VIII-XIV 
Chapters XV-XVIII 
Chapters XIX-XXII 

Chapters XXIII-XXIV 
Chapters XXV-XXVI 



CONTENTS 

CHAPTER PAGE 

I. Wealth i 

II. Property 21 

III. Capital 33 

IV. Income 55 

V. Addition of Income 69 

VI. Capitalizing Income 93 

VII. Variations of Income in Relation to Capital . 116 

VIII. The Equation of Exchange 132 s 

IX. Deposit Currency 153 

X. The Equation during Transition Periods . . 171 

XI. Influences outside the Equation . . . -179 

XII. Influences outside the Equation {Continued') . 191 

XIII. Operation of Monetary Systems .... 208 

XIV. Conclusions on Money 223 

XV. Supply and Demand 236 

XVI. The Influences behind Demand .... 256 

XVII. The Influences behind Supply .... 278 

XVIII. Mutually Related Prices 306 

XIX. Interest and Money 327 

XX. Impatience for Income the Basis of Interest . 338 

XXI. Influences on Impatience for Income . . . 348 

XXII. The Determination of the Rate of Interest . 360 

XXIII. Income from Capital 379 

XXIV. Income from Labor 401 

XXV. Wealth and Poverty 428 

XXVI. Wealth and Welfare 457 



xv 



CHAPTER I 



WEALTH 



§ i. Definition of Economics and of Wealth 

Economics may be most simply defined as the Science of 
Wealth. It is also known under several other titles, of 
which the most common is " Political Economy." The 
purpose of economics is to treat the nature of wealth ; the 
relation of wealth to human wants, and to the satisfaction 
of those wants ; the forms of the ownership of wealth ; the 
modes of its accumulation and dissipation ; the reasons that 
some people have so much of it and others so little ; and the 
principles that regulate its exchange and the prices which 
result from exchange. In a word, everything which con- 
cerns wealth in its general sense comes within the scope of 
economics. It is worth emphasizing at the outset, that 
the chief purpose of economics is to set forth the relations 
of wealth to human life and welfare. It is not, however, 
within the province of economics to study all aspects of 
human life and welfare, but only such as are connected in 
some manner with wealth. 

To most persons the chief interest in the subject lies in its 
practical applications to public problems, such as those 
connected with the tariff, taxation, currency, trusts, trade- 
unions, strikes, or socialism. These problems suggest that 
something is wrong in the present economic order of society 
and that there is a way to remedy it. But before we can 
treat of economic diseases, we must first understand the 
economic principles which these public questions involve. 
That is, the study of economic principles must precede the 
application of those principles to problems of public policy. 



2 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

In the end the student will reach more satisfactory con- 
clusions, if at the beginning he will put aside all thought 
of such applications, and cease to count himself a free trader 
or a protectionist, an individualist or a socialist, or, indeed, 
any other kind of partisan. 

We must, then, in the first place, distinguish economic 
principles from their applications to public problems ; in 
the second place, we must distinguish those principles from 
their applications to private problems. Economics does 
not concern itself with teaching men how to become rich ; 
nor does a practical skill in the art of becoming rich imply, 
necessarily, a sound knowledge of economics. Economics, it 
is true, represents the theory of business ; and business, the 
practice of economics. But, though they are not in the least 
conflicting — indeed, to some extent they are mutually 
helpful — economics and business are nevertheless totally 
different. The primary requisite of a good business man 
is to master the detailed facts which concern his own indi- 
vidual operations ; the primary requisite of a good economist 
is to master the general principles based on business facts. 
Some of the wildest economic theories have originated among 
successful financiers. Men who have been trained in Wall 
Street are often the, most sadly lacking in elementary 
instruction in economics. This is so because the very matters 
with which people have longest been familiar are frequently 
the ones which they have been least disposed to analyze. 
In business theory, no less than in the theory of public 
problems, men take too much for granted. 

Our first rule, then, in approaching the study of economics 
is to take nothing for granted. It is quite as important to 
be careful in defining familiar terms, such as " prices " 
and " wages," as in explaining unfamiliar ones, such as 
" index numbers " and " marginal utility." 

The chief purpose of this book is to define clearly the fun- 
damental concepts of economics and to state and prove the 
fundamental principles of the science. These concepts and 



Sec. il WEALTH 3 

principles will then serve as a basis for further study. In 
other books the student will find these concepts and prin- 
ciples applied to problems of public policy, or of business 
management, or of the economic history of nations. We 
are not concerned, in this book, with either practical prob- 
lems or economic history except as they are used occa- 
sionally to illustrate the principles under consideration. 

Wealth having been designated as the subject matter of 
economics, the question at once arises : What is wealth ? 
By wealth is meant material objects owned by human beings 
{and external to the owner). 1 Any one such object is an "ar- 
ticle of wealth," or an "instrument." Thus a locomotive 
is an article of wealth or an instrument. Other examples are 
an automobile, a horse, a house, a lot, a chair, a book, a 
hat, a loaf of bread, or a coin. 

1 Every writer may define a term as he pleases, except that he should 
justify his definition in one or both of two ways : (1) by showing that it 
accords with common practice; and (2) by showing that it leads to useful 
results. The above definition of wealth meets both of these requirements. 
It agrees substantially with the usual understanding of business men, and it 
leads to a consistent and systematic development of the science. 

Some economists add to the definition that an object, to be wealth, must be 
useful. But utility is really implied in ownership. Unless a thing is useful, 
no one would care to own it. Nothing is owned which is not useful in the 
sense that its owner hopes to receive benefits from it, and it is only in this 
sense that utility is to be employed as a technical term in economics. There- 
fore, as utility is already implied in ownership, it need not be mentioned 
separately in our definition. Other writers, while including in their defi- 
nition the idea of utility, omit the idea of ownership and simply define 
wealth as " useful material objects." But this definition includes too many 
"objects." Rain, wind, clouds, the Gulf Stream, the heavenly bodies, 
especially the sun, from which we derive light, heat, and energy, are all useful 
and material, but are not appropriated, and so are not wealth as commonly 
understood. Even more objectionable are those definitions of wealth which 
omit the qualification that it must be material; they do this in order to 
include stocks, bonds, and other property rights, as well as human and other 
services. While it is true that property and services are inseparable from 
wealth, and wealth from them, yet they are not themselves wealth. To in- 
clude wealth, property, and services all under " wealth," involves a 
species of triple counting. A railway, a railway share, and a railway trip are 
not three separate items of wealth ; they are respectively wealth, a title to 
that wealth, and a service of that wealth. 



4 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

In common parlance " wealth " is often opposed to 
" poverty," the contrast being between a large amount of 
wealth and a small amount; precisely as in common par- 
lance " heat " is opposed to " cold," the contrast being 
between a large degree of heat and a small degree. But 
just as in physics ice is regarded as having some degree of 
heat, so in economics a poor man is regarded as having some 
degree of wealth. 

Wealth, then, includes all those parts of the material 
universe that have been appropriated to the uses of mankind. 
It includes the food we eat, the clothing we wear, the dwell- 
ings we inhabit, the merchandise we buy and sell, the tools, 
machinery, factories, ships, and railways, by which other 
wealth is manufactured and transported, the land on which 
we live and work, and the gold by which we buy and sell 
other wealth. It does not include the sun, moon, or stars, 
for no man owns them. It is confined to this little planet 
of ours, and only to certain parts of that ; namely, the ap- 
propriated sections of its surface and the appropriated 
objects upon that surface. 



§ 2. Distinction between Money and Wealth 

One of the first warnings needed by the beginner is to 
avoid the common confusion of wealth with money. Few 
persons, to be sure, are so naive as to imagine that a million- 
aire is one who has a million dollars of actual money stored 
away ; but, because money is that particular kind of wealth 
in terms of which the value of all other kinds of wealth is 
measured, it is sometimes forgotten that not all wealth is 
money. 

We are not yet ready for an extended study of money, nor 
even for a definition of money, but as a warning we shall here 
enumerate a few of the most common fallacies which beset 
the subject. The nature of these fallacies the student will 



Sec. 2] WEALTH 5 

understand more fully after they have received a more 
extended treatment. 

First, among these fallacies, is the assertion that if one 
man " makes money," some one else must " lose " it, since 
there is only a fixed stock of money in the world, and it 
seems clear that " whatever money the money-maker gets 
must come out of some one else's pocket." The flaw in 
this reasoning is the assumption that gains in trade are 
simply gains in actual money, so that in every business 
transaction only one party can be the gainer. If this were 
true, we might as well substitute gambling for business and 
for manufacturing ; for in gambling the number of dollars 
won is equal to the number of dollars lost. As a matter 
of fact, however, it is not in order to obtain money that 
people engage in trade, but in order to obtain what money 
will buy, and that is precisely what both parties to a 
normal transaction eventually do obtain. 

Again, some persons have tried to prove that the people of 
the earth can never pay off their debts because these debts 
amount to more than the existing supply of money. " If 
we owe money," it is argued, " we can't pay more money 
than there is." This assertion sounds plausible, but a 
moment's thought will show that the same money can be, 
and in fact is, paid over and over again in discharge of several 
different debts ; not to mention that some debts are paid 
without the use of money at all. 

A few years ago at a meeting of the American Economic 
Association a Western banker expressed the opinion that 
the total amount of money in the world ought to be equiva- 
lent to the total wealth of the world; else, he suggested, 
people would never be able to pay their debts. He explained 
that in the United States there were twenty dollars of wealth 
for every dollar of money ; and he inferred that therefore 
there was but one chance in twenty of a debtor's paying his 
debts. " I will give five dollars," he said, " to any one who 
can disprove that statement." When no one accepted the 



6 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

challenge, a wag suggested that it was because there was but 
one chance in twenty of getting the promised five dollars ! 

The attempt to equalize money and wealth by increasing 
money twenty fold would, as we shall see later, prove abso- 
lutely futile. The moment we increased the amount of 
money, the money value of all other forms of wealth would 
rise, and there would, therefore, still be a discrepancy be- 
tween the amount of money and the amount of wealth. 

A very persistent money fallacy is the notion that some- 
times there is not enough money to do the world's business, 
and that unless at such times the quantity of money is 
increased, the wheels of business will either stop or slacken 
their pace. The fact is, however, that any quantity of 
money, whether large or small, will do the world's business 
as soon as the level of prices is properly adjusted to that 
quantity. In a recent article on this subject, an editor of a 
popular magazine put this fallacy into the very title : " There 
is not enough money in the world to do the world's work." 
He says, " The money is not coming out of the ground fast 
enough to meet the new conditions of life." In reality, 
money is coming out of the ground faster than the "new 
conditions " require, with the consequent result of raising 
prices. This writer contends that the panic of 1907 was 
due to a scarcity of money, whereas, if the principles to be 
explained in this book are correct, the panic was due to 
the fact that gold had been pouring out of the mines for 
so many years and in such large quantities that specu- 
lative tendencies were encouraged and precipitated an 
economic crash. 

A more subtle form of money fallacy is one which admits 
that money is not identical with wealth, but contends that 
money is an indispensable means of getting wealth. At a 
recent meeting of the American Economic Association a very 
intelligent gentleman asserted that the railways of this 
country could never have been built in the early fifties had 
it not been for the lucky discovery of gold in California in 



Sec. 2] WEALTH 7 

1849, which provided the " means by which we could pay 
for the construction of the railways." He overlooked the 
fact that the world does not get its wealth by buying it. 
One person may buy from another; but the world as a 
whole does not buy wealth, for the simple reason that there 
would be no one to buy it from. The world gets its railways, 
not by buying them, but by building them. What provides 
our railways is not the gold mines, but the iron mines. Even 
though there were not. a single cent of money in the world, 
it would still be possible to have railways. The gold of 
California enriched those who discovered it, because it en- 
abled them to buy wealth of others ; but it did not provide 
the world with railways any more than Robinson Crusoe's 
discovery of money in the ship provided him with food. If 
money could make the world rich, we should not need to 
wait for gold discoveries. We could make paper money. 
This, in fact, has often been tried. The French people once 
thought they were going to get rich by having the govern- 
ment print unlimited quantities of paper money. Austria, 
Italy, Argentina, Japan, as well as many other countries, 
including the American colonies, and the United States, 
have tried the same experiment with the same results — no 
real increase in wealth, but simply an increase in the amount 
of money to be exchanged for wealth. 

The idea that money is the essence of wealth was one of 
the ideas which gave rise to a set of doctrines and practices, 
called Colbertism or Mercantilism, the earliest so-called 
"school " of political economy. Colbert was a distinguished 
minister under Louis XIV of France in the seventeenth 
century, and a firm believer in the theory that, in order to 
be wealthy, a nation must have an abundance of money. 
His theory became known as Mercantilism because it re- 
garded trade between nations in the same light in which 
merchants look upon their business — each measuring his 
prosperity by the difference between the amount of money he 
expends and the amount he takes in. To keep money 



8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

within the country, Colbert and the Mercantilists advocated 
the policy now known as "protection." 

To-day it is generally understood that, in trade between 
nations, as in that between individuals, both parties may gain 
in an exchange transaction ; but the mercantilistic idea that 
a nation may get rich by selling more than it purchases, and 
collecting the "favorable balance of trade " in money, still 
forms one of the popular bases of protectionism in the United 
States. The more intelligent protectionists give quite differ- 
ent reasons for a protective tariff, but the old fallacious 
reason still appeals to the multitude. They continue to think 
that by putting up a high tariff so that people are prevented 
from spending money abroad and are compelled to keep 
it at home, the country will in some way be made richer. 

Money fallacies of the kinds we have described must be 
carefully avoided by the student. He should realize that 
no technical term, such as money, can be used as a basis of 
reasoning without a carefully formulated definition. All 
catch phrases should be avoided. Especially should the 
student be on his guard against every proposition concerning 
money. " Making money," for instance, is a catch phrase 
used without any definition. Properly speaking, nobody 
can "make" money except the man in the mint. The rest 
of us may gain wealth, but, unless we are counterfeiters, we 
cannot literally " make " money. 

§ 3. Classification of Wealth 

Various kinds of wealth may be distinguished. That 
kind of wealth which consists of portions of the earth's surface 
is called land. Among examples of land are to be included 
not only farms, city lots and streets, but mines, quarries, 
fisheries, waterways, etc. All waters which are owned are 
in economics called land, being a part of the surface of the 
earth. Fixed structures upon land are called land improve- 
ments. The chief examples of land improvements are houses 
and other buildings, fences, drains, railways, tramways, 



Sec. 3] 



WEALTH 



macadamized streets, etc. Land and land improvements 
taken together are called real estate, the word " real " 
signifying immovable. All wealth which is movable may 
conveniently be called commodities, although the usage for 
this term is not altogether certain. Among examples of 
commodities are wheat, pig iron, food, fuel, furniture, 
jewelry, clothing, books, chairs, machinery, etc. The term 
"commodities" also includes slaves, so far as this particu- 
lar species of wealth exists. 

It will be seen, however, that the definition of wealth 
which has been adopted excludes free human beings. It 
was in order to exclude free human beings from the category 
of wealth that the phrase " external to the owner " was in- 
serted in the definition. Slaves are wealth, for they are ex- 
ternal to their owner ; but freemen are not wealth. 1 

There are of course many admissible ways of classifying 
wealth. That which follows is intended to exhibit the prin- 
cipal groups into which wealth most naturally falls. It is 
advisable that the student construct other classifications for 
himself. 



Wealth 



Real Estate 



Commodities 



Land 



Land improve- 
ments 



Raw materials 



{Productive land 
Building land 
Ways of transit 

Buildings 
, Improvements 

on highways 
Miscellaneous 

I Mineral 
Agricultural 
Manufactured 



Finished products j Durao™^ 



1 Logically it would be permissible to omit the phrase "external to the 
owner " in the definition of wealth, and thus include freemen as wealth ; but 
it seems preferable in a textbook to make our definitions accord with or- 
dinary usage ; and in ordinary usage freemen are not called wealth. 



IO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

It scarcely needs to be stated that these groups are not 
always absolutely distinct. Like all classes of concrete 
things, they merge imperceptibly into one another. For 
this reason the classification is of importance only as it 
gives a bird's-eye view of the subject matter of economics. 

§4. Measurement of Wealth 

Having seen what wealth is and what it is not, and having 
classified it roughly, we shall next examine separately its 
two essential attributes, materiality and ownership, devoting 
the remainder of this chapter to the first of these. 

The materiality of wealth provides a basis for a physical 
measurement of the various articles of wealth. Wealth is 
of many kinds, and each kind has its own appropriate 
unit of measurement. Some kinds of wealth are measured 
by weight. This is true, for instance, of coal, iron, beef, 
and in fact of most " commodities." Of units of weight, 
a great diversity has been handed down to us, such as the 
pound avoirdupois, the kilogram, etc. In England, besides 
the avoirdupois pound, and the Troy pound, there is the 
pound sterling, used for measuring gold coin. This is much 
smaller than any other pound, owing partly to the frequent 
debasements of coinage that have occurred, and partly to 
changes in the past from silver to gold money. In the 
United States a dollar of " standard gold " (gold which is 
T^fine) is a unit of weight employed for measuring gold 
coin. It is equivalent to 25.8 grains, or to^wof a pound 
avoirdupois, since there are 7000 grains in a pound avoirdu- 
pois. We can scarcely put too much emphasis on the fact 
that the pound sterling and the dollar are units of weight. 
They should be understood as such before any attempt is 
made to understand them as units of " value." 

For many articles it is not so convenient to measure by 
units of weight as by units of space, whether of volume, of 
area, or of length. Thus we have, for volume, milk meas- 



Sec. 4] WEALTH 1 1 

ured by the quart, wheat by the bushel, wood by the 
cord, and gas by the cubic foot. For areas, we have lum- 
ber sold by the square foot, and land by the acre. For 
length, we have rope, wire, ribbons, and cloth measured in 
feet and yards. 

Many articles are already in the form of more or less 
convenient units. In these cases the measure of their 
quantity is the number of such units. For instance, eggs 
or oranges are usually measured by their number, expressed 
in dozens. Similarly, sheets of writing paper are reckoned 
by the " quire," pencils and screws by the " gross." In 
such cases the article is said to be measured " by number." 
But " number " is by no means peculiar to such cases. All 
measurement whatever implies an abstract number, as well 
as a concrete unit. The only peculiarity of so-called measure- 
ment " by number " is that the unit, instead of being one 
which is applied from the outside, as by the yardstick, is 
one into which the things measured happen to be already 
conveniently divided. 

In measuring the quantity of any particular kind of 
wealth it is assumed that the wealth measured is homogene- 
ous, or so nearly so as to admit of measurement by a given 
unit. If different qualities or grades have to be distinguished, 
the amount of each quality or grade requires separate meas- 
urement. A continuous gradation in quality, such as is 
usually found in real estate, makes it necessary to distinguish 
a great number of different qualities. A tract of land 
of 100 acres may consist of a dozen different qualities of 
land, variously adapted to pasture, crops, or other uses. 
To describe all this land as simply so many " acres " is 
misleading. It is necessary to specify separately the num- 
ber of acres of "pasture-land," "wheat-land," etc. 

The unit of measure of any kind of wealth, therefore, 
when fully expressed, implies a description, not only (1) of 
size, but also (2) of quality ; as, for instance, a " pound of 
granulated sugar." It is necessary to enumerate the attri- 



12 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

butes of the particular wealth under consideration, or 
enough of these attributes to distinguish that species of 
wealth from others with which it might be confused. 
Thus it is often necessary to specify what " grade " or 
" brand " is meant, as " grade A," " Eagle brand," etc. 
Sometimes the special variety is denoted by a " trademark " 
or " hall-mark." 

Some writers have erroneously supposed that the attrib- 
utes of wealth constitute separate and independent " im- 
material " sorts of wealth. But " fertility," for instance, 
is not wealth, though " fertile land " is wealth. " Sweet- 
ness " is not wealth, though " sweet sugar " is wealth ; 
" beauty " is not wealth, although a " beautiful gem " or 
other object of art is wealth ; " strength " and " power " 
are not wealth, although " powerful horses," automobiles, 
or waterfalls are wealth. 1 

§ 5. Price 

We have considered articles of wealth as measured sepa- 
rately. Each kind has its own special unit, as the pound, 
gallon, or yard. But it is convenient also to measure 
the combined value of aggregations of wealth. The term 
" value " introduces the subject of exchange. So much 
mystery has surrounded the term " value " that we cannot 
be too careful to obtain a correct and clear idea of it at the 
outset. In the explanation which follows, the concept of 
value is made to depend on that of price ; that of price, in 
turn, on that of exchange ; and finally, that of exchange on 

1 Some people speak of human qualities — strength, beauty, skill, honesty, 
intelligence, etc. — as though they were wealth. But these bear the same 
relation to human beings as similar qualities of articles of wealth bear to 
those articles; and the only way we can logically make them even attri- 
butes of wealth is, as already stated, to call human beings wealth. Then 
their attributes would be called attributes of wealth. But the definition of 
wealth which has been given better conforms to ordinary usage ; for in or- 
dinary usage neither free human beings nor their qualities are commonly 
called wealth. 



Sec. 5] WEALTH 



J 3 



that of transfer. In this section we shall treat of price; 
and, to observe the order of sequence, we must begin with 
transfer. 

Wealth is said to be transferred when it changes owners. 
A transfer is a change of ownership. Such a change does not 
necessarily imply a change of place. Ordinarily, of course, 
the transfer of an article is accompanied by a change in its 
position, the purchase of tea or sugar being accompanied 
by the physical delivery of these articles across the counter 
from dealer to customer ; but in many cases such a change of 
position does not occur, and in the case of real estate it is 
even impossible. 

Transfers may be voluntary or involuntary. Examples of 
involuntary transfers of wealth are : (1) through force and 
fraud of individuals, as in the case of robbery, burglary, or 
embezzlement ; (2) through force of government, as in the 
case of taxes, court fines, and " eminent domain." But 
at present we have to do only with voluntary transfers. 
These are of two kinds : (1) one-sided transfers, i.e., gifts 
and bequests; and (2) reciprocal transfers, or exchanges, 
which are of most importance for economics. Exchange, 
then, is the mutual and voluntary transfer of wealth between two 
owners, each transfer being in consideration of the other. 

When a certain quantity of wealth of one kind is exchanged 
for a certain quantity of wealth of another kind, we may 
divide either of the two quantities by the other and obtain 
what is called the price of the latter. That is, the price 
of wealth of one kind in terms of wealth of another kind is tlie 
ratio of exchange between the two, i.e., the ratio of the number 
of units of the latter to the number of units of tlte former 
which will be given in exchange. Thus if 200 bushels of 
wheat are exchanged for 100 ounces of silver, the price of 
the wheat in terms of silver is 100 -h 200, or one-half ounce 
of silver per bushel. Contrariwise, the price of silver in 
terms of wheat is 200 -f- 100, or two bushels per ounce. 
Thus there are always two prices in any exchange. Prac- 



14 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

tically, however, we usually speak only of one, viz., the 
price in terms of money, obtained by dividing the number 
of units of money by the number of units of the article ex- 
changed for that money. It follows that the price of any 
particular sort of wealth is the amount of money for which 
a unit of that wealth is exchanged. The fact that wealth 
is exchangeable and is in the civilized world constantly 
changing ownership is of great importance for our study. 
Articles of wealth which are seldom exchanged, such as 
public parks, are not commonly thought of as wealth at 
all, although logically they must be included in that cate- 
gory. 

While is it true that any two kinds of wealth may be 
exchanged, some kinds of wealth are more acceptable in ex- 
change than others. Money primarily means wealth which 
is generally acceptable in exchange. And here for the first 
time we reach a definition of money. This definition is 
based on the most important characteristic of money — its 
exchangeability. An exchange in which money does not 
figure is called barter. An exchange in which money does 
figure is called a purchase and sale — a purchase for the 
man who parts with the money, a sale for the man who re- 
ceives it. Originally, all exchange was barter, but to-day 
most exchange is, as we all know, purchase and sale. 

In order that there may be a price, it is not necessary that 
the exchange in question shall actually take place. It 
may be only a contemplated exchange. A real estate agent 
often has an " asking price " ; that is, a price at which he 
tries to sell. This is usually above the price of any actual 
sale which may occur later. In the same way there is often 
a "bidding price," which is usually below the price of actual 
sale. Hence, the price of actual sale usually lies between the 
price first bid and the price first asked. But it sometimes 
happens that the bidder refuses to raise his bidding price, and 
the seller refuses to lower his asking price enough to bring 
the two together. In such a case no sale takes place, and 



Sec. 5] WEALTH 15 

the only prices are those bid and asked. For many com- 
modities the trade journals report, preferably, prices of ac- 
tual sales ; but, where there have been no sales, they simply 
report the prices bid or asked, or both. 

When there is no sale, especially when there is no price bid 
or asked, it is not so easy to answer the question : What is 
the price? Recourse is then had to an " appraisal," which 
is simply a more or less skillful guess as to what price the 
article would or should bring. Appraising or guessing at 
prices is often very difficult. It frequently has to be em- 
ployed, however, by the government, for the purpose of 
assessing taxes and customs duties and condemning land ; 
by insurance companies for settling claims and adjusting 
losses ; by merchants for making up inventories and similar 
statements ; and by statisticians for numerous purposes. 
In fact, some people make a living by appraising wealth 
on which, for one purpose or another, a price of some sort 
must be set. The purpose evidently makes a great difference 
in the appraisal. Sometimes we want to know the price for 
which an article could be sold in an immediate forced sale ; 
sometimes, the price it might be expected to bring if a rea- 
sonable time were allowed ; sometimes, the price the owner 
would probably take; sometimes, the price a purchaser 
would probably give. These prices may all be different. 
A family portrait may be worth a big price to the owner, 
and yet bring next to nothing if sold to strangers. The 
owner would naturally appraise it at a high figure if he 
wished to insure it against fire, but if he should try to borrow 
money on it from a pawnbroker, the appraisal would un- 
doubtedly be low. 

Consequently, in applying an appraisal, we encounter 
many difficulties because the parties involved usually have 
some interest to serve. When a farmer has land for sale, 
he will hold it at a high price to prospective purchasers, 
but will enter it, if the truth must be told, at a low price on 
the tax list. When a fire loss is adjusted, the two conflicting 



i6 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 



interests, viz., the " insured " and the " company," are usu- 
ally represented by two experts, who in case of disagreement 
call in a third. 

§ 6. Value 

Having succeeded in defining the price of any kind of 
wealth, we may next proceed to define the value of any given 
quantity of that wealth. The value of a given quantity of 
wealth is that quantity multiplied by the price. 1 Thus, if the 
price of wheat is § of a dollar per bushel, then a lot con- 
sisting of 3000 bushels would have a value of 3000 times § 
of a dollar, or 2000 dollars. In other words, the value of a 
certain quantity of one kind of wealth at a given price is the 
quantity of some other land for which it would be exchanged, 
if the whole quantity were exchanged at the price set. 

The distinctions between quantity, price, and value of 
wealth may be illustrated by an inventory such as the fol- 
lowing : — 



QUANTITY 



PRICE IN TERMS OF WHEAT 



VALUE IN TERMS 
OF WHEAT 



Shoes . . . 
Beef . . . 
Dwelling house 
Wheat . . 



1000 pairs 
300 lbs. 

1 house 3 
100 bus. 4 



\\ bus. 2 per pair 
-5- bu. per pound 
10,000 bus. per house 
1 bu. per bushel 



4250 bus. 

60 bus. 

10,000 bus. 

100 bus. 



1 This definition of value departs from the usage of some textbooks, but 
follows closely that of business men and practical statisticians. Economists 
have sometimes confined "price" to what is here called money price and 
applied the term "value" to what is here called price. Other economists 
have used the term "price" in the sense of market price — what an article 
actually sells for — and "value" in the sense of appraised price or reasonable 
price — what it ought to sell for. Still others have used the term " price" 
in the sense employed in this book, but "value" in the sense of the degree of 
esteem in which an article is held — what in this book will later be called 
"marginal utility" or "marginal desirability." 

2 " Bushels " refers to bushels of wheat throughout this table. 

3 It is obvious from this example that where the quantity is itself the 
unit of measurement, price and value are identical. 

4 Here, for obvious reasons, quantity and value are identical. 



Sec. 6] WEALTH 1 7 

The measurement of various items of wealth in respect 
of " value," expressed in terms of a single commodity, such 
as wheat or money, has one great advantage over its 
measurement in respect of " quantity." This advantage is 
that it enables us to translate many kinds of wealth into 
one kind and thus to add them all together. To add up the 
" quantity " column would be ridiculous, because pairs of 
shoes, pounds of beef, houses, and bushels of wheat are un- 
like quantities. But the items in the last column (repre- 
senting values), being expressed in a single common unit 
(the bushel), may be added together despite the diversity of 
the various articles thus valued in bushels of wheat. 

Since prices and values are usually expressed in terms of 
money — the most exchangeable kind of wealth — money 
may be said to bring uniformity of measurement out of 
diversity. In other words, it is not only a medium of ex- 
change, but it can be used also as a measure of value. 

Although this reduction to a common measure is a great 
practical convenience, we must not imagine that it gives what 
could in any fair sense be called " the only true measure " 
of wealth. In fact, to measure the amount of wealth by its 
value — i.e., its money value — is often misleading. The 
money value of car wheels exported from the United States 
in one month was $12,000 and in a later month, $15,000, 
from which fact we might infer that the quantity of these 
exports had increased. But the number of car wheels 
exported in the first of those two months was 2200, and 
in the second only 2100, showing a decrease. The price 
had increased faster than the number had decreased. 
Likewise, the figures for imports of coffee in these periods 
show a decline in dollars, despite an increase in pounds. 
Here the price had fallen faster than the number of 
pounds had risen. It is conceivable that the quantity 
of every article might decrease, and yet the price simul- 
taneously increase so much that there would be an appar- 
ent increase of wealth when there really was nothing of 



18 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

the kind. This is apt to be the case in times of inflation 
of the currency. 

Even when we are confessedly trying to measure the value 
of wealth and not its quantity, it is difficult or impossible 
to find a right way. Imports into the United States from 
Mexico in one year were worth twenty-eight millions of 
American gold dollars, and ten years later their value was 
forty millions — an increase in value of forty- two per cent ; 
but these very same imports measured in Mexican silver 
dollars were forty-one millions in the first year and ninety 
millions in the second — an increase in value of nearly one 
hundred and twenty per cent. These two rates of in- 
crease, although they represent exactly the same facts, do 
not agree with each other; yet the American merchant 
reckons the values one way, and the Mexican merchant, 
the other. In a sense both are right ; that is to say, both 
are true statements of the value of the articles imported, 
one of the value in gold and the other of the value in 
silver. If the value were to be measured in iron, copper, 
coal, cotton, or any other article, we should have many 
other different " values," no two of which would necessarily 
agree. " The value of wealth," therefore, is an incomplete 
phrase ; to be definite we should say, " the value of wealth 
in terms of gold," or in terms of some other particular 
article. Hence we cannot employ such values for compar- 
ing different groups of wealth, except under certain condi- 
tions, and to a limited degree. To compare the wealth 
values of distant places or times — as America and China, 
Ancient Rome and Modern Italy — will inevitably give 
conflicting and unsatisfactory results. 

§ 7. Limit of Accuracy in Economic Measurements 

We have learned how the three magnitudes — quantity, 
price, and value of wealth — are usually measured, and that 
their measurement is practically a very inaccurate affair. 



Sec. 7] WEALTH 19 

Yet in the minds of most persons, even of business men, the 
degree of accuracy attainable is exaggerated. Even in the 
measurement of the mere quantities of wealth there are two 
sources of error ; for every such measurement includes, as 
we have seen, two elements : a unit and a number or ratio 
(as the pound, and the number of pounds) ; and both the 
unit and the number or ratio may be inaccurate. In modern 
times the first source of error — that of the unit — is practi- 
cally eliminated. Our units of weight and measure are 
standardized by law, and a pound in California is, for all 
practical purposes, equal to a pound in Connecticut. There 
is, moreover, at Washington a national bureau and a special 
building for preserving and testing standards of measurement. 
Different towns have their sealers of weights and measures, 
to prevent error through ignorance or fraud. Fraud still 
exists, but is much rarer than in former times. The Egyp- 
tians are said to have been unable to test the accuracy of 
their units of length to less than 1 part in 350. The Roman 
weights were true only to 1 part in 50. And when we go 
back to primitive units, we find that they were very rough 
indeed. A yard was probably at first the length around 
the waist, which naturally was apt to vary considerably. 
So also the distance between the elbow and the end of the 
finger was taken as a unit and called the ell. Fraud was, 
therefore, as easy as it was common. At Bergen, in Norway, 
among other relics of the old Hanseatic League, are the 
scales used for buying and selling fish, with two sorts of 
weights used, one considerably heavier than the other. 
The heavier were used for buying and the lighter for selling ! 
Such tampering with weights and measures is now seldom 
heard of, although instances, as in the recent sugar frauds, 
are not unknown. 

To-day, therefore, the chief source of error lies not in the 
unit, but in the ratio of the quantity of wealth to that unit. 
In retail trade the inaccuracy from this source is very great. 
If we get our apples or potatoes measured correctly within 



20 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

five per cent, we are fortunate. Wholesale transactions 
are more accurate. Probably the greatest degree of accu- 
racy ever attained in commercial measurements is on the 
mint scales employed by the federal government in Phila- 
delphia and San Francisco. These scales weigh accurately 
to within about one part in two million. 

Besides the two sources of error in the measurement of 
mere quantity, when we proceed from quantity to value, 
we introduce still a third source of inaccuracy, viz., the price 
factor by which we multiply the quantity in order to get 
the value. This is especially true if the price be merely an 
" appraised " price. The price in an actual sale is an abso- 
lute fact and cannot be said to have any inaccuracy; but 
the price at which we estimate that a thing would sell under 
certain conditions is always uncertain. In the case of 
" staple " articles, i.e., articles regularly on the market, a 
dealer can often appraise correctly within one per cent. 
Real estate in certain parts of a city where sales are active 
can sometimes be appraised correctly within five or ten per 
cent, but in the " dead " or out-of-the-way parts of some 
towns where sales are infrequent, the appraisement be- 
comes merely a rough guess. Again, in the country districts, 
while farms in the settled parts of Iowa and Texas can be ap- 
praised within ten or fifteen per cent, in the backward parts 
even an expert's valuation is often proved wrong by more 
than fifty per cent. And where a sale of the article in 
question is scarcely conceivable, an appraisement is almost 
out of the question. To estimate the value of Yellow- 
stone Park is impossible, unless we allow ourselves enor- 
mous limits of error. 



CHAPTER II 



PROPERTY 



§ i. The Benefits of Wealth 

The definition of wealth which has been given restricts it 
to concrete material objects. Accordingly, wealth has two 
essential attributes : materiality and ownership. Its mate- 
riality was the subject of the preceding chapter; its 
ownership will be the subject of the present chapter. 

To own wealth is to have a right to the benefits of wealth, 
and before proceeding further with the discussion of owner- 
ship we must consider these " benefits " of wealth. To 
own a loaf of bread means nothing more nor less than to have 
the right to benefit by it — i.e., to eat it, sell it, or otherwise 
employ it to satisfy one's desires. To own a suit of clothes 
is to have the right to wear it. To own a carriage is to 
have the right to drive in it or otherwise utilize it as long 
as it lasts. To own a plot of land means to have the right 
to use it forever. The real objects for which wealth exists 
are the benefits which it confers. If some one should give 
you a house on condition that you should never use it, sell 
it, rent it, or give it away, you might be justified in refusing 
it as worthless. 

Benefits may also be rendered by free human beings, who, 
according to our definition and ordinary usage, are not called 
wealth. Such benefits are then usually called services 
rendered or work done. When rendered by things rather 
than persons, benefits are commonly called uses. Some- 
times benefits consist of positive advantages and sometimes 



22 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

of the prevention of disadvantages. Benefits, then, mean 
desirable events obtained or undesirable events averted by means 
of wealth or free human beings. For example, when' a 
loom changes yarn into cloth, the transformation is a de- 
sirable change due to the loom ; it is a benefit conferred or 
performed by the loom. The benefit from a plow is the 
turning up of the soil. The benefits or services performed 
by a bricklayer consist in the laying of bricks. The benefits 
or uses conferred by a fence around a farm consist in pre- 
venting the cattle from roaming away. The dikes in 
Holland confer the benefit of keeping out the ocean. The 
benefits conferred by a diamond necklace consist in its 
pleasing glitter. 

To be desirable to the owner, an article must confer bene- 
fits on the owner, but not necessarily on the community 
at large. For instance, the noise of a factory whistle may 
be a nuisance to the community, but as long as it is service- 
able to the owner of the factory, it is for him a benefit. 
Benefits to the owner and benefits to society may be very 
different or may be mutually incompatible. The benefits to 
society are of the greater importance, but, under our present 
system of ownership, the benefits to the owner control the 
prices and values of wealth. In order, therefore, to under- 
stand prices and values as they are actually determined, 
we must fix our attention for the present on the benefits to 
the owner rather than on those to society. 

Benefits maybe measured just as wealth maybe measured, 
although the units of measurement are of course not the same. 
We measure some benefits by number — as when we count 
the strokes of a printing press. We measure other benefits 
by time — as when we reckon a laborer's work by the number 
of hours or days during which he works. Some benefits 
we measure by the quantity of wealth which is produced or 
treated — as when the work of a coal miner is measured by 
the amount of coal he mines, or when the use of a loom is 
measured by the number of yards of cloth it weaves, or 



Sec. 2] PROPERTY 



23 



when the services of a lawn-mowing outfit are measured by 
the number of acres covered. The measurement of services 
or benefits is usually rougher than that of wealth, because 
it is more difficult to establish units of measure. The shel- 
ter of a house or the use or "wear" of a suit of clothes is 
difficult to measure accurately. To save trouble, benefits 
are usually measured by time, although, as soon as it be- 
comes profitable to do so, the tendency is to establish a 
more satisfactory measure " by the piece." 

When we have measured the benefits of wealth or persons, 
we may apply to them the same concepts of transfer, ex- 
change, price, and value, which, in the last chapter, we 
applied to wealth. We have seen that wealth may be ex- 
changed. The same is true of benefits. But to exchange 
wealth is really to exchange the benefits of wealth, for the 
only object in getting wealth is to get its benefits. 

§ 2. The Costs of Wealth 

Opposed to the benefits of wealth are its costs. Costs 
may be called negative benefits. The purpose of wealth is 
to benefit its owner ; that is, to cause to happen what he 
desires to happen, and to prevent from happening what he 
does not desire to happen. But often wealth can work no 
benefit without entailing some cost, i.e., preventing what is 
desirable or occasioning what is undesirable. For instance, 
one cannot enjoy the benefits of a dwelling without the costs 
of taking care of it, either through the actual labor of clean- 
ing, heating, repairing, and keeping it in order, or the payment 
of money to servants for such purposes ; one cannot get the 
benefit of flour without assuming the cost of kneading and 
baking it into bread ; one cannot get the benefit of a farm 
without the cost of tilling it. Whatever wealth brings 
about to the pleasure of the owner is a benefit; whatever 
it brings about to his displeasure is a cost. He assumes the 
costs only as a means of securing the benefits. Costs are 



24 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

thus the necessary evils which must be if we are to obtain 
the good which wealth affords. 

Like benefits, costs are not only occasioned by wealth, 
but also by human beings. An employer can only get 
benefits from a workman at the cost of paying him wages, 
an independent workman can only get benefits from his 
own exertions at the cost of his own labor. 

The costs of wealth or of human beings may, of course, 
be measured, just as benefits are measured — by number, 
by time, or by other appropriate units. 

§ 3. Property, the Right to Benefits 

We have said that to own wealth means to have the right 
to its benefits. We have seen what is meant by " bene- 
fits," and shall next examine what is meant by " rights." 

A property right is the liberty, under the sanction and 
protection of custom and law, to enjoy benefits of wealth and 
assume the costs which those benefits entail. The term 
''property" is merely an abbreviation for a property right or 
property rights. Just as different kinds of wealth are more 
or less exchangeable, so different kinds of property rights 
differ greatly in exchangeability. Those forms which are 
most easily and commonly exchanged are of most impor- 
tance for our study. Those the exchange of which is in- 
frequent, difficult, or forbidden, are in fact seldom thought 
of as property rights at all, although logically they must 
be included in that category. In the modern world the 
right of a parent over a child or of a husband over a 
wife is not by ordinary usage called property ; for, except 
in certain remote corners of the earth, their exchange is 
tabooed. 

It will be observed that property rights, unlike wealth or 
benefits, are not physical objects nor events, but are abstract 
social relations. A property right is not a thing. It is that 
relation of man to things, called ownership. It is in this 



Sec. 3] PROPERTY 25 

human relationship to wealth that we are most interested, 
and not in the physical objects as such. 

The benefits to which a right to wealth entitles its pro- 
prietor require time for their occurrence and are either past 
or future. The past and the future are separated by the 
present, which is a mere point of time. The only benefits 
from wealth which can be owned at this present point of 
time are future benefits. Past benefits have vanished. 
When a man owns any form of property, he owns a right 
to future benefits. The idea of " futurity " must therefore 
be added to our definition, making it read : Property is the 
right to future benefits of wealth. But even yet we are not 
quite done with our definition. For the future is always 
uncertain ; no man can ever tell in advance exactly how much 
future benefit he can obtain ; he can only take the chances 
and risks involved. We must therefore add to our definition 
the idea of uncertainty. The definition will now read : 
Property is the right to the more or less probable future benefits 
of wealth. If a man has the right to all the benefits 
which may come in the future from a particular article of 
wealth, he is said to have its complete ownership, or its 
ownership "in fee simple." If he has a right to only some of 
the benefits from a particular article of wealth, he is said to 
own that wealth partially, or to " have an interest " in it. 
When two brothers own a farm equally in partnership, each 
is a part owner ; each has an interest in the farm ; that is, 
each has a right to half of the benefits to be had from the 
farm. What is divided between the two brothers is not 
the farm, but the benefits of the farm. To emphasize this 
fact, the law describes each brother's share as an " undivided 
half interest." Partnership rights are usually employed only 
when the number of coowners is small. When the number 
is large, the ownership is usually subdivided into shares of 
stock ; but the principle is the same — each individual owns 
a right to a certain fraction of the benefits which come to 
the owners. 



26 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

The measurement of property rights is in practice less 
thoroughly worked out than that of wealth, though more so 
than that of benefits. After the quantities of property cf dif- 
ferent kinds are measured, we may apply the same concepts 
of transfer, exchange, price, and value which have already 
been applied to wealth and benefits, each particular kind 
being measured in its own particular unit. Consider, for 
example, the property called stock in the Pennsylvania 
Railway Company. This is measured by the " number of 
shares," the share here being the unit of measurement. 

It is important that the student should become accustomed 
to see the real basis underlying property rights. This basis 
is either wealth or persons, or both. Practically it is usually 
wealth. A mortgage is based on land, and great care is 
taken not to have the mortgage too large for the basis on 
which it rests. Railroad stocks and bonds are based on the 
real railway. Personal notes are based partly on the 
person issuing them and partly on his wealth. A street 
railway franchise is a property right, the physical basis of 
which consists in the streets. Sometimes the property 
rights are removed several steps from the real basis. If a 
number of factories are combined into a " trust," the origi- 
nal stockholders surrender their stock to trustees and re- 
ceive in their place trust certificates. Their rights are then 
a claim against the trustees who hold the stock which rep- 
resents the factories. The ultimate basis for their rights 
is still the factories, but their ownership is indirect. 

The future benefits flowing from wealth may be compared 
to a pennant attached to a flagstaff — a long streamer 
stretching out into the future. Some of the possible ways 
in which the present ownership of these pennants may be 
subdivided is indicated in Fig. i, which contains two such 
" streamers." The first represents the stream of benefits 
from a dwelling house. These begin at the present and 
stretch out indefinitely into the future. If two brothers 
own the house in partnership, each has a right to half the 



Sec. 4] 



PROPERTY 



27 



B's SHARE OF FUTURE BENEFITS 



A'S SHARE OF FUTURE BENEFITS 



shelter of the house, i.e., to half of its benefits ; the benefits 
are therefore divided, so to speak, longitudinally in time. 

But if the house is rented, the division of benefits between 
the tenant and the landlord is transverse, as shown in the 
lower " streamer " of the diagram. The tenant has all 
the benefits of the house for a certain time, after which 
the landlord has all the remaining benefits. 

These are not, of course, the only ways in which future 
benefits may be parceled out among their several owners, 
but they are the prin- 
cipal and usual modes 
of subdivision. 

In common speech, 
the minor rights to 
wealth are not ordi- 
narily dignified as 
rights of ownership. 
Thus a tenant's right 
in the dwelling he oc- 
cupies is sharply dis- 
tinguished from the 
right of the owner. 
Yet, strictly speaking, 

every right to use wealth, however insignificant, is a part 
ownership. When an owner of land wishes to sell an 
unencumbered title, he finds it necessary to extinguish all 
outstanding leases, or claims for future benefits, often at 
considerable cost. It is the total ownership which he is 
selling, and the total ownership always includes the owner- 
ship which the tenant enjoys. 



Tenant's 

SHARE 



Landlord's 

SHARE 



Present 

INSTANT 



Fig. 1. 



§ 4. The Relation between Wealth and Property 

We have thus far considered three very important and 
fundamental concepts : wealth, benefits, and property. A 
convenient collective term for all of them is " goods." 



28 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

Wealth and property are only present representatives of 
future benefits and costs. Wealth and free human beings 
are the present means by which we secure future benefits ; 
while property is the present right to these benefits, and so 
to the wealth which yields them. It follows that wealth 
and free human beings, on the one hand, and property 
rights on the other, may be said to correspond to one another. 
Wealth and persons are real tangible things, while property 
rights represent the intangible, abstract relation which 
the persons, as owners, hold toward the wealth. Wealth 
and persons are the important things ; property is the human 
right of ownership of the wealth. In specific cases we can 
readily see the correspondence between the wealth and 
its ownership. In fact, in cases where wealth is owned 
" in fee simple " or completely, the correspondence is alto- 
gether too obvious ; so obvious that in ordinary parlance 
the two terms, " wealth " and " property," become con- 
fused, as when speaking of a piece of wealth, in the form, 
say, of land, we call it a " piece of property." 

On the other hand, where the ownership is minutely 
subdivided, the wealth and the property rights to that 
wealth become so dissociated in our minds that we are apt 
to fall into the opposite error, and completely lose sight of 
their connection. For instance, when railway shares are 
sold in Wall Street, the investor rarely thinks of those shares 
as connected with any actual wealth. All that he sees are 
the engraved certificates of his property rights; he has no 
visual picture of the railway. Sometimes the rights are so 
far separated from the thing to which the rights relate, that 
people are unaware that there is anything behind the rights 
at all, and delude themselves with the notion that there 
need not be anything behind them. A government bond, for 
instance, is often regarded as a kind of property behind which 
there is no wealth. But if we examine the case, we shall 
find that the wealth of the entire community is behind 
this property right; for it is by means of the taxing power 



Sec. 4] PROPERTY 29 

that the bonds are to be paid, and it is by means of the 
wealth taxed that the taxing power is effective. For cities, 
in fact, this is definitely recognized ; there is usually a 
legal debt limit expressed in terms of the value of taxable 
wealth, to insure the creditors that there shall always be 
sufficient real wealth behind the city bonds to make their 
ultimate payment secure. 

Not only should the student clearly distinguish in his 
mind between these three important concepts of wealth, 
benefits and property, but he should avoid confusing any of 
these important concepts with a fourth relatively unimpor- 
tant concept, namely, certificates of ownership. To avoid 
misunderstanding, it is often necessary that property rights 
should be evidenced by written documents. Examples of 
such written evidences or certification of property rights are 
deeds for real estate, receipted bills for goods bought and paid 
for, engraved stock certificates, railway tickets, signed prom- 
issory notes, etc. It is clear, however, that such written evi- 
dence of property rights is very different from the property 
rights themselves; and in many cases such rights exist 
without any written evidence. Thus, the farmer who 
rears his own cattle, or horses, or sheep, usually has no 
written evidence of property rights in them. Or, two 
brothers might own and operate a farm in partnership, 
without any written evidence as to their partnership rights, 
i.e., their respective rights in the products of the farm. Or, 
again, one person might, without written evidence, lease 
(say) a cottage for a season from a friend. In all these 
cases, though there are no written or documentary evi- 
dences of property rights on the part of the persons in- 
volved, yet such rights do exist : in the first case, in fee 
simple ; in the second, divided longitudinally in time ; and 
in the third, divided transversely in time. 



30 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

§ 5. Practical Problems of Property 

Since wealth and persons, on the one hand, and property 
rights, on the other, correspond so closely, economics 
might be called the science of property as well as the 
science of wealth. When we treat of the welfare of a 
community, we think rather of wealth than of property. 
When we treat of the welfare of an individual, we think 
rather of property than of wealth. This fact of corre- 
spondence between property rights, on the one hand, and 
wealth and persons, on the other, should be emphasized, 
because it will save us from confusions which are all too 
common, and it will save us also from many practical 
blunders growing out of these confusions. If our State 
legislators understood this principle, there would be less of 
the iniquitous double taxation that is the bane of the present 
systems of State and local taxation. Such unjust taxation 
is illustrated by the case of the Massachusetts factory owner 
who decided to transfer his property to a stock company of 
which he himself should hold all the stock. Previously he 
paid taxes only on the factory itself ; but when the " com- 
pany " was formed, the tax collector came along and informed 
him that henceforth not only must the " company " pay 
taxes on the factory, but that he personally must pay taxes 
on the stock also, since stock is taxable " personal property." 
Thus the owner was taxed both on the stock which repre- 
sented the factory and on the factory itself. Instances 
of double taxation are quite common in the United States, 
though they are not all so self-evident as this. 

Many of the most important problems of economic 
policy are problems of the form of ownership of wealth. 
The great question of slavery, for instance, turned upon the 
question whether one man should be owned by another. 

A more modern problem of property is that of perpetual 
franchises. Is it, for instance, good public policy to grant to 
a street railway company in perpetuity the rights to use a 



Sec. 5] PROPERTY 3 1 

city's streets? Or ought we to fix a time limit, say fifty 
years, after which the rights shall revert to the city? A 
kindred question has been raised as to private property in 
land. Is it wise public policy that the present form of land 
ownership in fee simple should continue? Ought a man 
to have the right to a piece of land forever, perhaps abus- 
ing that right, obstructing others, and neglecting the oppor- 
tunities which it affords ; or should the government step in 
and lease the land for limited periods? This question is 
now being discussed with reference to our mineral lands, 
and particularly our coal lands in Alaska. Questions of 
land ownership have in all ages vexed men's minds and 
been the source of social unrest. Rome had her agrarian 
troubles, not unlike those of modern England and Ireland. 

The right to bequeath property is also a prime source of 
trouble. This right to dispose of property by will has not 
always been recognized. It was developed by the Romans, 
from whose system of law we borrowed it. Even now it 
is a limited right, and its exercise differs with law and custom. 
These differences are responsible for peasant proprietorship 
in France and for primogeniture in England. The right has, 
indeed, been limited so as to prevent the perpetual tying-up 
of an estate by a testator. Its further limitation will prob- 
ably be one of the problems of the future. 

An even broader question of the same sort is the question 
of socialism. Shall we discontinue what is called private 
property, except in the things that we wear and eat, and pos- 
sibly the houses in which we live? That is, shall we allow 
our railways and our factories to be owned by private indi- 
viduals? Or shall they be owned by the community at 
large so that we may all have shares in them, as we already 
have in the post office and the government printing office ? 

These are some of the greatest problems in economics ; 
and they are problems concerning the ownership of wealth. 
The answers to these questions do not come within the pur- 
pose of this book, which is concerned merely with principles. 



32 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 



The problems are merely mentioned as illustrating the ap- 
plication of principles here discussed. 

§ 6. Table of Typical Property Rights 

The following table indicates the most important types of 
property, and shows in each case the wealth on which the 
property right is based and the benefits accruing from 
that wealth. The most important forms are : fee simple, 
stocks, bonds, notes, leases, and partnership rights. 

TYPICAL CASES ILLUSTRATING THE EXISTENCE OF 
WEALTH BEHIND PROPERTY RIGHTS 



Name of Case 


Wealth on which 
the Property 
Right is Based 


Benefits of 
that Wealth 


Description of 
Property Right 


Certificate 

of Ownership, 

if Any 


Fee Simple 


Farm 


Yielding crops 


Right to all use 
of farm for- 
ever 


Deed 


Partnership 


Dry goods 


Yielding profits 


One partner's 


Articles of 






from sale 


" undivided " 
one-third in- 
terest 


agreement 


Joint Stock 


Railway 


Yielding profits 


The shares of 
stock 


Stock certifi- 
cate 


Street Franchise 


Street 


Use of same for 
passage, etc. 


Right to run 
cars through 
it 

Right of tenant 


Charter 


Lease or Eire 


Dwelling 


Use of same for 


Lease 






shelter, etc. 


till fixed date 




Railway Ticket 


Railway 


Transportation 


Right to speci- 
fied trip 


Ticket 


Railway Bond 


Railway 


Payment of " in- 


Right to same 


Bond certifi- 






terest " and 


and contin- 


cate 






" principal " 


gent right to 
foreclose 




Personal Note All the posses- 


Payments 


Right to same 


Note 




sions of the 




and in de- 






signer 




fault thereof, 
right to collat- 
eral security 





CHAPTER III 

CAPITAL 

§ I. Capital and Income 

In the foregoing chapters we have set forth several funda- 
mental concepts of economics — wealth, property, benefits, 
price, and value. We have seen that wealth consists of 
material appropriated objects, and that property consists of 
rights in these objects or in free human beings ; that benefits 
are the desirable occurrences which happen through wealth 
or free human beings ; that prices are the ratios of exchange 
between quantities of goods of various kinds (wealth, 
property, or benefits) ; and that value is price multiplied 
by quantity. These concepts are the chief tools needed in 
economic study. 

Little has yet been said about the relation of these various 
magnitudes to time. When we speak of a certain quantity 
of wealth, benefits, or property, we may refer either (i) 
to a quantity existing at a particular instant of time, or (2) 
to a quantity produced, exchanged, transported, or consumed 
during a particular period of time. The first is a stock of 
" goods "; the second is a. flow of " goods." Examples of 
stocks are the stock in trade of a merchant on a certain 
date, the cargo of wheat carried by a ship, the amount of 
food in a pantry at a particular instant, the number of shares 
of stock owned by a particular individual in a particular 
corporation at a particular date. Examples of flows are the 
sales of merchandise made in the course of a given month 
by a given merchant, the amount of wheat imported during 

d 33 



34 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

a given year, the quantity of food consumed by a family in a 
given week, the sales of a given kind of stock on the New 
York Stock Exchange during a given number of days, the 
transportation accomplished by a railway in the course 
of a certain year, the work done by a given man in a given 
time. 

The most important purpose of the distinction between a 
stock and a flow is to differentiate between capital and income. 
Capital is a stock, and income a flow. This, however, is not 
the only difference between capital and income. There is 
another, equally important ; namely, that capital consists 
of wealth or property, while income consists of benefits. We 
have, therefore, the following definitions : A stock of wealth or 
property existing at a given instant of time is called capital; 
a flow of benefits from wealth or property through a period of 
time is called income. Many authors restrict the name 
capital to a particular kind or species of wealth, or to 
wealth used for a particular purpose, such as the production 
of new wealth ; in short, to some specific part of wealth in- 
stead of any or all of it. Such a limitation, however, is not 
only difficult to make, but cripples the usefulness of the con- 
cept in economic analysis. 

A dwelling house is capital; the shelter or the rent it 
affords, during any given period of time, is income. The 
railways of the country are capital; their benefits (in the 
form of transportation or its equivalent in dividends) are 
the income they yield. 

§ 2. Capital-goods, Capital-value, Capital-balance 

We have defined capital as a stock of goods (wealth or 
property) existing at a given point of time. An instantane- 
ous photograph of wealth would reveal, not only a stock of 
durable wealth, but also a stock of wealth more rapid in 
consumption. It would disclose, not the annual procession 
of such goods, but the members of that procession that had 



Sec. 2] CAPITAL 35 

not yet passed off the stage of existence, however swiftly 
they might be moving across it. It would show trainloads 
of meat, eggs, and milk in transit, as well as the contents of 
private storerooms, ice chests, and wine cellars. Even the 
supplies on the table of a man bolting his dinner would find 
a place. So the clothes in one's wardrobe, or on one's back, 
the tobacco in a smoker's pouch or pipe, the oil in the can 
or lamp, would all be elements in this flashlight picture. 

The examples just given are all instances of wealth. 
But when the ownership of wealth is subdivided, any indi- 
vidual may have as his capital, not whole railways or ships, 
but merely shares or other partial property rights in them. 
Thus the typical capitalist of to-day is a person whose cap- 
ital consists mostly of stocks, bonds, mortgages, and notes. 

We have seen in the last two chapters that wealth and 
property may be measured either by quantities (such as so 
many bushels or pounds or so many shares or bonds of a 
particular description) or by value (such as so many dollars' 
worth) . When a given collection of capital is measured in 
terms of the quantities of the various goods of which it is 
composed, it is sometimes called capital-goods ; when it is 
measured in terms of its value, it is sometimes called capital- 
value. 

One of the best methods of understanding the nature of 
capital is to understand the method of keeping capital ac- 
counts. We shall therefore in the remainder of this chapter 
indicate some of the principles cf capital accounting. Such 
a study is useful not only because it enables us to keep our 
own capital accounts and to understand the accounts of 
banks, railways, and other institutions as published, but, 
what is more important for our present purpose, because 
it shows how in the present complicated world of divided 
ownership of capital, with its interrelated arrangement of 
stocks, bonds, debts, and credits, the capitals of individuals 
dovetail into one another, forming together the capital of 
the community. 



36 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

A capital account or balance sheet is a statement of the 
quantity and value of the wealth and property of a specific 
owner at any instant of time. It consists of two columns — 
the assets and the liabilities — the positive and negative items 
of his capital. The liabilities of an owner are his debts and 
obligations to others ; that is, they are the property rights of 
others for which this owner is responsible. The assets or 
resources of the owner include all his capital, irrespective of 
his liabilities. The assets include both the capital which 
makes good the liabilities, and that, if any, in excess of the 
liabilities. 

The owner may be either a physical human being or an 
abstract entity called a " fictitious person " made up of a 
collection of human beings and keeping a balance sheet 
distinct from those of the individuals composing it. Ex- 
amples of fictitious persons are an association, a joint stock 
company, a government. With respect to a debt or liabil- 
ity, the person who owes it is the debtor, and the person 
owed is the creditor. The difference in value between the 
total assets and the total liabilities in any capital account 
is called the net capital, or capital-balance of the person or 
company whose account it is. 

A fictitious person is to be regarded as owning all the 
capital nominally intrusted to it and as owing its individ- 
ual members for their respective shares. The most im- 
portant example of a fictitious person is a joint stock 
company. This may be roughly described as an aggrega- 
tion of individuals uniting for the purpose of holding prop- 
erty jointly, and so organized that the individual shares 
of ownership and management are represented by " stock 
certificates." Associated with the stockholders are usually 
also bondholders without voting power, but with the right 
to- receive fixed payments stipulated in the bonds which 
they hold. 

The items in a capital account are constantly changing, 
as also their values ; so that, after one statement of assets 



Sec. 2] CAPITAL 37 

and liabilities is drawn up, and another is constructed at a 
later time, the balancing item, or net capital, may have 
changed considerably. However, bookkeepers are accus- 
tomed to keep the recorded " capital " item unchanged from 
the beginning of their account, and to characterize any in- 
crease of it as " surplus " or " undivided profits " rather 
than as capital. There are several reasons for this book- 
keeping policy. In the first place, the less often the book- 
keeper's entries are altered, the simpler the bookkeeping. 
Again, by stating separately the original capital and its later 
increase, the books show at a glance what the history of the 
individual or company has been as to the accumulations of 
net capital. Finally, in the case of joint stock companies, 
the stockholders' capital is represented by stock certificates, 
the engraved " face value " of which cannot conveniently 
be altered to keep pace with changes in real value. Conse- 
quently, it is customary for bookkeepers to maintain the 
book value of the recorded " capital," or " capital-balance," 
equal to the face value of the certificates. But this book- 
keeping policy does not alter the fact that at a given instant 
the owner's capital consists of the entire excess of his assets 
over his liabilities, including in that excess the accumulated 
surplus and undivided profits. If the excess of assets over 
liabilities be added to the liabilities, the two sides of the 
account will exactly balance. A capital account so made out 
is therefore called a " balance sheet." 

The following two balance sheets illustrate the accumula- 
tion in a year of that part of capital which bookkeepers sepa- 
rate from the " capital " item and call " surplus." 

JANUARY 1, 1910 
Assets Liabilities 

Plant $200,000 Debts $100,000 

Capital (owed to the 

stockholders) . . 100,000 

$200,000 $200,000 



38 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

JANUARY 1, 1911 
Assets Liabilities 

Plant, etc $246,324 Debts $100,000 

Capital 100,000 

Surplus 46,324 

$246,324 $246,324 

Not only is the book item, " capital," maintained intact 
as long as possible, but often the surplus also is put in 
round numbers and kept at the same figure for several succes- 
sive reports. This leads bookkeepers to distinguish a third 
part of the capital, namely, the odd sum usually existing 
in addition to the even surplus. This third item is called 
" undivided profits," and is subject to constant fluctuation 
from one date to another. The distinction between sur- 
plus and undivided profits is thus merely one of degree. 
The three items — capital, surplus, and undivided profits — 
together make up the total present net capital or capital 
balance. Of this, " capital " represents the original capi- 
tal, "surplus " the earlier and larger accumulations, and 
" undivided profits " the later and minor accumulations. 
The undivided profits are more likely soon to disappear in 
dividends, i.e., to become divided profits, although this may 
also happen to the surplus, or even in certain cases to the 
" capital " itself. 

We see, then, that the capital of a company, firm, or 
person, is to be understood in two senses : first, as the item 
entered in the balance sheet under that head — the original 
capital ; and secondly, this sum plus surplus and undivided 
profits — the true net capital at the instant under considera- 
tion. 

In the case of a joint stock company, since the stock 
certificates were issued at the time of the formation of the 
company, and cannot be perpetually changed, they ordi- 
narily correspond to the original capital instead of the present 
capital. Recapitalization may be effected, however, by 



Sec. 3] CAPITAL 39 

recalling the stock certificates and issuing new ones. In this 
way the nominal or book value may be either decreased or 
increased. It is sometimes scaled down because of shrinking 
assets, and sometimes increased because of new subscrip- 
tions or expanding assets. If, for instance, the original 
capital was $100,000, and the present capital (including the 
surplus and undivided profits) is $300,000, it would be pos- 
sible, in order that the total certificates outstanding might 
become $300,000, and the surplus and undivided profits be 
enrolled as capital, to issue stock certificates to the amount 
of $200,000 free to the holders of the original stock. Such 
an issue of stock is called a stock dividend. Ordinarily, 
however, the stock certificates remain as originally, and 
merely increase in value. Thus, if the present capital is 
$300,000, whereas the original capital or the outstanding 
certificates amounted to only $100,000, the " market value " 
of the shares will be triple the " face value " ; for the stock- 
holders own a total of $300,000, represented by certificates 
the face value of which is $100,000. 

§ 3. Book and Market Values 

If, however, we attempt to verify such a relation by refer- 
ence to the company's books, we shall find some discrepancies 
in the results. For instance, a certain bank of New York 
recently reported a total capital, surplus, and undivided 
profits of $1,295,952.59, of which the original capital was 
only $300,000. We should expect, therefore, that the stock 
certificates, the total face value of which was $300,000, 
would be worth $1,295,952.59 ; or, in other words, that each 
stock certificate with a face value of $100 would be worth 
$432. The actual selling price, however, was about $700. 
The discrepancy between $432 and $700 is due to the fact that 
there are two estimates of the value of capital — one that 
of the bookkeeper, which is seldom revised and usually 
conservative, and the other that of the market, which is 



40 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

revised almost daily. The stockholders of this bank were 
credited by the bookkeeper with owning $1,295,952.59, 
whereas, in reality, the total value of their property was more 
nearly $2,100,000. The bookkeeper systematically under- 
valued the assets of the bank, and even omitted some valu- 
able assets altogether, such as " good will." The object of a 
conservative business man in keeping his books is not to 
obtain mathematical accuracy, but to make so conservative 
a valuation as to be well within the requirements of the law 
and expediency. The law discountenances the valuation of 
assets above their original cost ; and sometimes there is an 
additional motive to keep secret the real size of the surplus 
in order not to invite competition or in order to escape 
taxation. 

Of the two valuations of the capital of a company, the 
bookkeeper's and the market's, the latter is apt to be the 
truer of the two, although it must be remembered that each 
of them is merely an appraisement. The ordinary book- 
keeper's figures, which have so imposing an appearance of 
accuracy, are, in reality, and often of necessity, very wide of 
the mark. For instance, a certain bank recently reported its 
capital, surplus, and undivided profits at $444,814.40, but 
at the same time the president of the bank boasted that the 
banking house was entered among the assets at $20,000, while 
its real value was probably $50,000. Thus the figure giving 
the capital, surplus, or undivided profits, instead of being 
correct to the last cent or even the last dollar, was not 
correct even to the last ten thousand dollars. 

§ 4. Case of Decreasing Capital-balance 

We have seen that the effect upon the balance sheet of an 
increase in the value of the assets is to swell the surplus or 
the undivided profits. Conversely, a shrinkage of value 
tends to diminish those items. For instance, if the plant of 
a company having a capital of $100,000 and a surplus of 



Sec. 4] CAPITAL 41 

$50,000 depreciates to the extent of $40,000, the effect 
on the account will be as follows : — 



ORIGINAL BALANCE SHEET 

Assets Liabilities 

Plant .... $200,000.00 Debts .... $150,000.00 

Miscellaneous . . 101,256.42 Capital .... 100,000.00 

Surplus .... 50,000.00 
. Undivided profits . 1,256.42 



$301,256.42 $301,256.42 

PRESENT BALANCE SHEET 

Assets Liabilities 

Plant $160,000.00 Debts .... $150,000.00 

Miscellaneous . . 101,256.42 Capital .... 100,000.00 

Surplus .... 10,000.00 
Undivided profits 1,256.42 



$261,256.42 $261,256.42 

Here the shrinkage in the value of the plant, as recorded on 
the assets side, " comes out of the surplus," as recorded on 
the liabilities side. 

In case the surplus and undivided profits have both been 
wiped out, the capital itself becomes impaired. In this case 
the bookkeeper may indicate the result by scaling down the 
capitalization. This sometimes occurs in banks and trust 
companies, but not often in ordinary business. It is often 
avoided by making up the deficiencies through assessment 
of stockholders or postponement of dividends. Such meas- 
ures are required by law in many cases, as in that of insurance 
companies. 

Dishonest concerns, however, often conceal their true con- 
dition by the reverse process of exaggerating the value of the 
assets. Sometimes this is done systematically, as in the case 
of stock- jobbing concerns. The sums intrusted to unscrupu- 
lous promoters by confiding stockholders are often invested 



42 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

in unwise or fraudulent ways. For instance, take an Oil 
Well Company in California, of the illegitimate type called 
" stock-producing wells." Suppose it borrows $50,000 and 
collects $50,000 more from the sale of stock (at par), and 
with this $ioo,oco purchases land at a fancy price from friends 
who collusively agree that a part of the proceeds shall be 
secretly returned to the promoter. In such a case the books 
of the bubble concern will show the following figures : — 

Assets Liabilities 

Land $100,000 Debts . ..... $50,000 

Capital 50,000 

$100,000 $100,000 

But if the land is worth, say, only $60,000, these accounts 
should have been quite different, viz. : 

Assets Liabilities 

Land $60,000 Debts $50,000 

Capital 10,000 

$60,000 $60,000 

In other words, the investor has only $10,000 worth of 
property, instead of the $50,000 which he put in, or 20 cents 
for every dollar invested. The rest has been diverted into 
the pockets of the promoter and of those in collusion with 
him. 

This is stock jobbing. It is one example of what, in 
commercial slang, is called " stock watering," being an 
issue of stock whose nominal or face value is greater than the 
actual capital. Another and more usual use of the term 
" stock watering" makes it mean not an issue of stock beyond 
the real commercial capital-value as it is at the time, but 
an issue of stock beyond the original cost value of the capital 
as shown by the actual money paid in. Thus a " trust " 
may buy up a number of factories and then capitalize them 



Sec. 5] CAPITAL 43 

far beyond that cost, because the combination of the factories 
gives them a monopoly value beyond the sum of their val- 
ues when separate. By watering the stock, concealment is 
made of the fact that the trust is earning an enormous rate 
of dividends in proportion to the original investment ; 
for the dividends make a much smaller rate on the inflated, 
or watered, capitalization than on the cost value. Stock 
watering, in whatever sense the term is used, is usually 
employed for the purpose of concealing the facts regarding 
the true or the original value of the capital. It is sometimes 
said that there is no wrong in such stock watering, so long 
as it is fully known. This is much like saying that to he 
is not wrong, provided everybody knows you are lying. 
Stock watering of the kind described is the exaggeration of 
the " capital " item entered on the liabilities side of the bal- 
ance sheet ; and, since the two sides must balance, it in- 
volves the exaggeration of the assets also. It usually rep- 
resents an intention to deceive, and through this deceit 
injury may be done both to buyers of stock and buyers of 
bonds. The buyers of stock are injured if they buy without 
knowledge of the proposed stock watering, and the bond 
buyer is injured if the watering of the stock, having given 
him a false idea of the actual capital, induces him to lend 
more money than the capital can satisfactorily secure. 

§ 5. Insolvency 

The original capital of a concern may be either increased 
or decreased. In the course of its fluctuation it may some- 
times shrink to zero. If it shrinks below zero, we have 
" insolvency " — the condition in which the assets fall 
short of the liabilities other than capital. The capital- 
balance is intended to prevent this very calamity ; it is for 
the express purpose of guaranteeing the value of the other 
liabilities — those to bondholders and other creditors. 

These other liabilities, for the most part, are fixed blocks 



44 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

of property, carved, as it were, out of assets, the value of 
which property the merchant or company has agreed to keep 
intact at all hazards. The fortunes of business will naturally 
cause the whole volume of assets to vary in value, but all 
the " slack " ought properly to be taken up or given out by 
the capital, the surplus, and the undivided profits. A man's 
capital thus acts as a safety fund or buffer to keep the liabili- 
ties from overtaking the assets. It is the " margin " he 
puts up as a guarantee to others who intrust their capital to 
him. 

The amount of capital-balance necessary to make a busi- 
ness reasonably safe will differ with circumstances. A capi- 
tal-balance equal to five per cent of the liabilities may, in 
one kind of business, such as the business of a mortgage 
company, be perfectly adequate, whereas 50 per cent may 
be required in another kind. Much depends on how likely 
the assets are to shrink, and to what extent; and much, 
likewise, depends on the character of the liabilities. 

The risk of insolvency is the chance that the assets may 
shrink below the liabilities. This risk is the greater, the 
more shrinkable the assets, and the less the margin of capital- 
value between assets and liabilities. 

Insolvency must be distinguished from insufficiency of 
cash. The assets may comfortably exceed the liabilities, 
and yet the cash assets at a particular moment may be less 
than the cash liabilities due at that moment. This condi- 
tion is not true insolvency, but only insufficiency of cash. 
In such a case, a little forbearance on the part of creditors 
may be all that is necessary to prevent financial shipwreck. 

A wise merchant, however, will not only avoid insolvency, 
but also insufficiency of cash. He will not only keep his as- 
sets in excess of his liabilities by a safe margin, but he will 
also see that his assets are invested in such a manner that 
he shall be able, by exchanging them for cash, to cancel 
each claim at the time and in the manner agreed upon. 

From this point of view there are three chief forms of 



Sec. 5] CAPITAL 



45 



assets ; namely, cash assets, quick assets, and slow assets. A 
cash asset is in actual money, or what is acceptable in place 
of money. A quick asset is one which may be exchanged for 
cash in a relatively short time, as, for instance, gold or silver 
bullion, wheat, short-time loans, and other marketable se- 
curities. A slow asset is one which may require a relatively 
long time to be exchanged for cash. Such are real estate, 
office fixtures, and manufacturers' equipment. 

If all property were as . acceptable as money, there would 
be no need of classifying assets into these three groups. 
But since the creditor will not accept railway stock or bonds, 
when he has contracted for payment in money, the debtor 
must maneuver so as to keep on hand a sufficient quantity 
of cash assets to enable him to meet his immediate obli- 
gations and enough quick assets to enable him to exchange 
them for cash in time to meet obligations soon to fall due. 
A large part of the skill of a business man consists in marshal- 
ing his assets so that he always has enough cash and enough 
quick assets to provide for impending debts, while maintain- 
ing at the same time enough slow assets to insure a satis- 
factory income from his business. 

Originally, before business was separated from private life, 
all of a debtor's assets, even including his own person, were 
regarded as pledged to the payment of a debt. An insolvent 
debtor could be imprisoned. To-day, however, laws exist 
in most countries by which a bankrupt may, under certain 
conditions, be discharged, free from further liability. 

Since the liabilities of one man are also the assets of 
another, when one man fails and is able to pay only fifty 
cents on the dollar, the unlucky man who is his creditor — 
who has the first man's notes as assets — suffers a shrinkage 
in his own assets which may in turn mean embarrassment 
or even bankruptcy to him. It is usually true in a panic that 
the failures start with the collapse of some big firm, involv- 
ing a shrinkage in the assets of others. This indicates why 
assets ought usually to be undervalued. A man who is in 



46 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

debt has no right to exaggerate his means of payment. A 
conservative and honest business man will always under- 
value rather than overvalue his assets, in order to be fair to 
his creditors. 

§ 6. Two Methods of Combining Capital Accounts 

We have seen how the capital account of each person in a 
community is formed. Our next task is to express the total 
net capital of any community. This is the sum of the net 
capitals of its members, i.e., all the innumerable assets of all 
the persons less all the liabilities of those persons. This net 
sum will be the same, of course, in whatever order the items 
are added and subtracted. We might write each item on a 
slip of paper, marking each asset item as positive and each 
liability item as negative, and, shuffling them into any ran- 
dom order, add and subtract them one by one according as 
they are positive or negative. But there are two ways in 
particular which need to be emphasized. 

The simplest is, first, to obtain the net capital-balance of 
each person by subtracting the value of his liabilities from 
that of his assets, and then to add together these net capitals 
of different persons to get the capital of society. This 
method of obtaining society's net capital may be called the 
method of balances; for we balance the books of each indi- 
vidual. The other method is to cancel each liability against 
an equal and opposite asset, which, as we shall see, must 
exist somewhere in another individual's account, and then 
add the remaining assets. This method may be called the 
method of couples; for we couple items in two different 
accounts. The method of couples is based on the fact that 
every liability item in a balance sheet implies the existence 
of an equal asset in some other balance sheet. This is true 
because every debit implies a credit. It follows that every 
negative term in one balance sheet may be canceled against 
a corresponding positive term in some other. Each of these 



Sec. 6] 



CAPITAL 



47 



two methods — of balances and of couples — is important 
in its own way. 

Let us illustrate each by the balance sheets of three per- 
sons, say X, Y, and Z. 



Assets 



Z's note . . 
Residence . . 
Railroad shares 



PERSON X 

Liabilities 

$30,000 A Mortgage held by Y . $50,000 b 
70,000. (Capital balance . 70,000) 
20,000 





$120,000 


$120,000 




PERSON Y 




Assets 


Liabilities 




X's mortgage . . 
Personal effects 
Railroad shares . 


. $50,000 B Debt to Z . . . . 
. 20,000 (Capital balance . 
. 10,000 


$40,000 c 
40,000) 




$80,000 


$80,000 




PERSON Z 




Assets 


Liabilities 




Y'sdebt . . . 
Farm .... 
Railroad bonds . 


$40,000 C Debt to X ... 
50,000 (Capital balance . . 
20,000 


$30,000 a 
80,000) 



Si 10,000 



Si 10,000 



The capital-balance for each person is indicated in a paren- 
thesis inserted in the liabilities column. Each of these items 
is obtained by subtracting the other liabilities of their 
respective accounts from the assets. The sum of these 
three items is the total net capital of X, Y, and Z, and is 
thus obtained by the method of balances. To show the 
method of couples in the table, each couple of corresponding 
items — i.e., each item which appears twice, once as a liability 
of one man and again as an asset of another — is indicated 
in both places by the same letter. Thus, " A " in " X's " 
assets is matched by the equal and opposite item " a " in 



48 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

Z's liabilities. The method of couples thus consists in 
canceling, and, therefore, omitting from society's balance 
sheet, these pairs of items, and entering and adding only 
those which remain uncanceled. These, in the present 
case, are all assets. Adding these, we again obtain a sum 
representing the total net capital of X, Y, and Z, this time 
by the method of couples. 

The results of summing up the capital accounts by the 
two methods are shown in the following tables : — 



Method of Balances Method of Couples 



X's capital .... $70,000 Residence . 
Y's capital .... 40,000 Personal effects 
Z's capital .... 80,000 Farm 



Railroad shares 
Railroad bonds 



£70,000 
20,000 
50,000 
30,000 
20,000 



$190,000 $190,000 

The totals are the same by both methods, but the method 
of balances exhibits the share of this total capital which is 
owned by each individual, while the method of couples ex- 
hibits the portion ascribable to each different capital-good. 

§ 7. Real and Fictitious Persons 

It is well to note here the distinction between the account- 
ing of real persons and of fictitious persons. For a real per- 
son, the assets may be, and usually are, in excess of the 
liabilities, and the difference is the capital balance of that 
person. This capital is not to be regarded as a liability, 
but as a balance or difference between the liabilities and the 
assets. For a fictitious person (i.e., a corporation, partner- 
ship, association, etc., regarded as independent of the per- 
sons comprising it), on the other hand, the liabilities are al- 
ways exactly equal to the assets ; for the balancing item called 
capital is as truly an obligation (from the fictitious person to 
the real stockholders) as any of the other liabilities. For 



Sec. 8] CAPITAL 49 

instance, the items entered as " capital," " surplus," and 
" undivided profits" in the accounts of a joint stock company- 
do not belong to the company, as such, but to the stock- 
holders. So far as the " company " is concerned, they are 
its liabilities; they represent what it owes to the stockholders, 
just as the other items of liabilities represent what it owes to 
the bondholders, etc. A fictitious person, in fact, is a mere 
bookkeeping dummy, holding certain assets and owing all of 
them out again to real persons, including the stockholders. 

§ 8. Ultimate Result of Method of Couples 

Let us now introduce into our addition the capital ac- 
counts of the railroad whose stocks and bonds were included 
among the assets of persons X, Y, and Z. For simplicity, 
we shall suppose that these three persons are the only 
persons interested in the road. The balance sheet of the 
railroad company will accordingly appear as follows : — 

RAILROAD COMPANY 
Assets Liabilities 

Railway $50,000 Bonds (held by Z) . . $20,000 

Capital stock 
(held by X) $20,000 
(held by Y) $10,000 30,000 

$50,000 $50,000 

If now, by the method of balances, we combine this balance 
sheet with those of X, Y, and Z, we shall see that its inclu- 
sion does not affect the results which were obtained by the 
same method before the railroad was introduced into the 
discussion. The totals will stand as follows : — 

X's capital balance $70,000 

Y's capital balance 40,000 

Z's capital balance 80,000 

Railroad Co.'s capital balance .... 00,000 

$190,000 



50 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

When we apply the method of couples, we find, however, 
that the inclusion in our consideration of the railway 
company's capital account will affect the items, though not 
the final sum. The stocks and bonds, as assets of X, Y, 
and Z, will then pair off or couple with the corresponding 
liabilities of the railroad company, and their place will be 
taken by the concrete railroad itself, as follows : — 

Method of Couples 

Residence $70,000 

Personal effects 20,000 

Farm 50,000 

Railway 50,000 

$190,000 

The appearance of the capital inventory is thus changed. 
Formerly, the items of property rights in it included such 
part-rights as stocks and bonds; now they consist only of 
complete property rights. But the complete right to any 
article of wealth is best expressed in terms of the article of 
wealth itself. Consequently, instead of the long phrase, 
the " right to a residence," we may merely use the term 
" residence." The property no longer veils the wealth be- 
neath it ; and the inventory, which before was an inventory 
of both capital wealth and capital property becomes an in- 
ventory of only capital wealth. 

Such a result is sure to follow when we combine capital 
accounts, provided we combine enough of them to supply, 
for every liability item, its counterpart asset, and for every 
asset which has one, its counterpart liability. Those assets 
which have no counterparts are what we have called com- 
plete rights to wealth, or " fees simple" ; those assets which do 
have canceling counterparts are the partial rights to wealth. 
The reason is that every article of concrete wealth is to be 
regarded as owned in " fee simple " by some one, even if 
we have to set up a fictitious person or dummy for that 



Sec. q] CAPITAL 



51 



very purpose. Hence, every part-right to such an article 
of concrete wealth will necessarily appear as a liability on 
the liability side of the fictitious person's account. Thus, 
if two brothers own a farm in equal shares, the shares will 
appear as assets in the brothers' individual accounts; but 
since the farm as a whole is regarded as owned by the partner- 
ship person called " Smith Brothers," the balance sheet of 
this fictitious person will show as assets the farm itself, and 
as liabilities the " undivided half interest " of each brother. 

To follow out totals of capital thus requires the inclusion 
of many fictitious persons, for it is often only the fictitious 
persons who hold the complete rights. Locomotives and 
railway stations, for instance, are owned by corporations, 
not individuals. In fact, these fictitious persons — partner- 
ships, corporations, trusts, municipalities, associations, and 
the like — are devices for the express purpose of holding 
large aggregations of concrete wealth and parceling out its 
ownership among a number of real persons. 

If, then, we suppose balance sheets so constructed as to 
include all the real and fictitious persons in the world, with 
entries in them for every asset and liability, — even public 
parks and streets, household furniture, and other possessions 
not formally accounted for in ordinary practice, — it is evi- 
dent that we shall obtain, by the method of balances, a 
complete account of the distribution of capital-value among 
real persons ; and, by the method of couples, a complete 
list of the articles of actual wealth thus owned. In this list 
there will be no stocks, bonds, mortgages, notes, or other 
part-rights, but only land, buildings, and other land improve- 
ments, and commodities. 

§ 9. Confusions to be Avoided 

Among the forms of part-rights in real wealth is "credit." 
Credit is a debit or debt looked at from the standpoint of the 
creditor. There has been much discussion as to the nature 



52 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

of credit ; whether, in particular, credit is to be regarded as 
capital. It has been claimed that from the merchant's 
point of view credit is capital because it enables a business 
man to enlarge his business. But this view entails double 
counting. We have seen from our study of capital accounts 
how to avoid such double counting. That part of a man's 
so-called capital which is borrowed cannot enter his books 
as his capital at all, being merely a manifestation of the fact 
that the total capital of the community is owned in part by 
others. Indeed, the phenomenon of credit means nothing 
more nor less than a specific form of divided ownership of 
wealth. Credit merely enables one man temporarily to 
control more wealth or property than he owns — i.e., some 
part of the wealth or property of others. 

It is therefore a cardinal error to regard credit as in- 
creasing the capital of the debtor. Indirectly, credit may 
result in an increase of society's capital, by stimulating 
trade and production, as well as by getting the management 
of capital into the right hands and its ownership into the 
most effective form. In these ways the earth is made to 
yield up more wealth, or greater benefits from the same 
wealth — in either case entailing an increase of capital ; but 
the amount of any such increase of capital thus indirectly 
produced bears no necessary relation to the amount of the 
credit which facilitated its production. Even when capital 
is increased through credit, the credit does not constitute 
the increase. 

A great deal of confusion in legislation and discussion could 
be avoided if the two methods of combining capital accounts 
were distinguished and their interrelations recognized. In 
taxation, the two methods are often confused. A chief 
problem of efficient taxation is how to tax all property once, 
and none of it more than once. There are two solutions. 
One is to tax the amount owned by each real person as ob- 
tained by the method of balances; this method seeks out 
the real owners or part-owners of wealth. The other is to 



Sec. 9] CAPITAL 53 

tax the actual concrete wealth as obtained by the method 
of couples ; this method seeks out the real wealth owned. 
In short, one method follows the person, the other the thing. 
At present the two methods are much confused. Legislators 
too often fail to perceive that under the first, or owner- 
method, corporations should not be taxed, for they are not 
true owners ; and that under the second, or wealth-method, 
bonds, stocks, and other part-rights to wealth should not 
be taxed, for these are already taxed when the actual rail- 
ways and other items of physical wealth underlying such 
part-rights are taxed. It is not claimed, of course, that a 
complete system of taxation can be worked out merely by 
choosing one of the two methods just indicated. But the 
distinction between the two should be borne in mind, when- 
ever any scheme of taxation is considered ; for where one 
system is applied, the other cannot also be applied without 
double taxation. 

The study of capital accounting, therefore, enables 
us to avoid many common confusions. More important 
still, it gives us a clear picture of the relations between the 
capital of a community and the capital of the individuals 
of which the community is composed, i.e., between the 
stocks of actual wealth in a community and the stocks of 
property representing the ownership of this wealth among 
different individuals. In short, it enables us to see both 
individually and as a whole the items which make up private 
and collective property, as stocks, bonds, mortgages, debts, 
etc., on the one hand, and land, ships, dwellings, and other 
concrete wealth, on the other. 

In the light of the foregoing principles we are in a position 
to take a bird's-eye view of the capital in any country. In 
America, for instance, we find a stock of wealth of various 
kinds with an estimated value of over $100,000,000,000. 
More than half of this consists of real estate ; about ten 
per cent consists of railways and their equipment ; manu- 
factured products make up about $8,000,000,000 ; furniture, 



54 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

carriages, and kindred articles about $6,000,000,000 ; live 
stock on farms about $4,000,000,000; tools, implements, 
and machinery in factories about $3,000,000,000; clothing 
and personal adornments about $2,500,000,000; street 
railways about $2,000,000,000; agricultural products about 
$2,000,000,000; gold and silver coin and bullion about 
$2,000,000,000; and numerous other smaller items. The 
ownership of this real wealth is divided up in various ways. 
To a very large extent, especially in the case of farms, the real 
estate is owned completely by the occupier. In other cases 
it is mortgaged, the occupier then owning merely the excess 
of value over the mortgage. Of the national capital apart 
from real estate, on the other hand, probably by far the 
greater part is owned by corporations, which means, of 
course, simply that its ownership is parceled out among the 
stockholders and bondholders of these corporations. From 
what has been said the student will not make the mistake 
of adding the value of stocks and bonds to the value of 
real wealth which these represent. Stocks, bonds, mort- 
gages, and other items which are assets to some persons are 
liabilities to others, and thus cancel themselves out for the 
country as a whole. The student will also notice how in- 
significant is the stock of gold and silver as compared with 
the total capital, although the value of all is measured in 
terms of gold. 



CHAPTER IV 

INCOME 

§ i. Concepts of Income and Outgo 

The income from any particular article of wealth has been 
defined as the flow of benefits from that article. These bene- 
fits may sometimes consist of money payments ; but it is 
important to avoid the mistaken notion that they always 
consist of money payments. Income is the flow of whatever 
benefits accrue from any article, whether these benefits 
happen to be in the form of money payments or not. A self- 
supporting farmer, for instance, may not receive or expend 
a single dollar from one year's end to the other. He has, 
nevertheless, an income. He gets a " living " — the very 
essence of income — from the farm. A windmill pumps 
water ; the pumping is the benefit or income resulting from 
the windmill. A derrick hoists coal from a mine ; the hoist- 
ing is the income from the derrick. A wife does housework ; 
her work is an item of the family's income. The warmth 
and shelter that a house provides for its occupants constitute 
the income furnished by the house. All the operations of 
industry and all the transactions of commerce are items of 
income. When axes fell trees and sawmills turn them into 
lumber, these changes constitute items in the income flowing 
from the agencies which produce them. When a manufac- 
turing plant converts raw materials into food or into fabrics 
or into implements, these changes constitute income pro- 
duced by the plant. What we call agriculture, mining, 

55 



56 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

commerce, and domestic operations yield benefits which 
constitute large and important classes of income. 

Practically, of course, most of the examples given of bene- 
fits or services are not income to the owner of the instru- 
ments rendering those services; for, practically, those 
services are not enjoyed by the owner, but are sold to some 
one else, the owner receiving a money payment instead. 
Thus, although a farmer may get his living directly from the 
farm, it is more usual for him to sell some of the farm products 
and to receive money payments instead. Likewise it may 
be that the owner of the windmill pumps water for others 
and receives money payments in return; and that the 
owner of a house sells its use for a money rental ; and simi- 
larly the owners of the derrick, axes, sawmill, manufacturing 
plant, etc., do not get the direct benefit of the hoisting, 
cutting, sawing, manufacturing, etc., but exchange these for 
money payments. In such cases the owners get their in- 
come in the form of money payments by selling to others 
the direct benefits of their capital. Thus their capital yields 
them an indirect money income through the sale of the direct 
income produced by the capital. So usual is it for the 
owner of capital to sell his natural income for a money 
income that ordinarily we think of income as consisting only 
in such money return. One of the early economists seri- 
ously maintained that the owner of a house could receive 
no income from it except by renting it, forgetting that to 
rent a house is merely to sell the shelter income for money 
income. A man who lives in his own house gets the shelter 
income directly. A man who lets his house to another 
secures a money income as the equivalent of the shelter in- 
come which the tenant receives. 

Income, being a flow of benefits, implies a stock or fund 
of instruments which produces the flow. This stock of in- 
struments is what we have already designated as "capital." 

It has already been noted that income differs from capital 
in two respects. In the first place, income is a flow relating 



Sec. i] INCOME 57 

to a given period, whereas capital is a fund relating to a 
given instant. In the second place, income consists of 
(intangible) benefits, whereas capital consists of (tangible) 
instruments ; not farms, therefore, nor houses, nor food, nor 
railroads, nor artesian wells, nor instruments of any sort can, 
strictly speaking, ever constitute income. Income consists 
rather in the yielding of crops by the farms ; the warming 
and sheltering of people by the houses; the nourishing of 
people by the food ; the transporting of passengers and 
freight by the railroads ; the raising of water by the wells ; 
and benefits of any sort rendered by instruments of wealth. 

Although income consists partly of other benefits than 
money receipts, all income, like all capital, may be translated 
into terms of money. And to all items of income as to those 
of capital may be applied the concepts of price and value. 

Thus far we have considered only the positive side of in- 
come accounts. But just as in our capital account we found 
a negative side — comprising the liabilities — so we shall 
find a negative side to income. The negative of income is 
called outgo, and the items which constitute outgo are called 
costs. A cost occasioned by an article has already been 
defined as the opposite of a benefit. It is an undesirable 
event occasioned by that article. Labor, trouble, expense, 
and sacrifices of all sorts are entailed by wealth and are 
counted among its costs. An instrument seldom confers 
benefits without also involving costs. A dwelling, while it 
gives shelter, compels its owner to assume important costs 
in keeping it in repair, painting it, cleaning it, caring for it, 
insuring it, and paying taxes upon it. A saddle horse yields 
income to the owner when it gives him a pleasure ride, but 
it requires feeding, stabling, and shoeing — the negative side 
of the account, constituting the outgo or flow of costs oc- 
casioned by the horse. A farm produces benefits in yielding 
crops ; but it requires fertilizing, tilling, and seeding, all of 
which are costs occasioned by the farm. A railroad pro- 
duces benefits called " transportation" — hauling passengers 



58 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

and commodities ; but it involves an expenditure of money, 
it burns coal, it requires labor ; and these are the outgo, or 
the negative side of its account. 

Costs, too, may be measured in money just as income may 
be measured in money ; and some costs consist in the actual 
expenditure of money, just as some benefits consist in the 
receipt of money. Strictly speaking, neither consists of actual 
money. We must therefore distinguish carefully three 
money items : (1) money on hand at an instant of time, 
which is an example of capital; (2) the receipt of money 
during a period of time, which is an example of income (from 
whatever instrument it may be which occasions the receipt 
of the money) ; and (3) the expenditure of money during a 
period of time, which is an example of outgo (on the part of 
whatever instrument it may be which occasions the expense) . 

In general, the costs of a given item of capital are out- 
weighed by its benefits. For if it should occasion more 
costs than benefits, it would be thrown away, thereupon 
ceasing to be wealth according to our definition. Or if it 
should still remain in any one's possession, it might be called 
negative wealth, of which ashes, rubbish, garbage, etc., are 
familiar examples. 

Costs are never voluntarily assumed except in the hope 
of benefits which will make them worth while. The total 
gross income {i.e., the value of the benefits of wealth) minus 
the total outgo {i.e., the value of its costs), constitutes net 
income. Thus, just as net capital is found by subtracting 
the liabilities from the assets in a capital account, so net 
income in an income account is found by subtracting the 
value of the costs from the value of the benefits. Both bene- 
fits and costs, moreover, are attributable to a definite capital 
source. In income-accounting the benefits or income-items 
are credited to capital, and the outgo or cost-items are 
debited to capital. In keeping income accounts, therefore, 
it is important to know to what category of capital any item 
of income should be credited, or any item of outgo debited. 



Sec. 2] INCOME 59 

§ 2. Income Accounts 

We are now in a position to apply the foregoing definitions 
to income accounts. Perhaps no other subject in economics 
has been so fraught with confusion, misunderstanding, and 
double counting as income. It will help the student to 
understand these accounts if he will bear in mind that they 
show the income and outgo which any given capital (or free 
human being) yields. We are apt to think of income and 
outgo too much with reference to the owner of the sources 
by which the income and outgo are occasioned. It will be 
easy later to make up the owner's income account; but 
first we must construct the income account for an individ- 
ual article of capital. 

We may begin by imagining a certain " house and lot " 
as one composite instrument or article of wealth, and may 
first consider its income and outgo during the calendar 
year 1910. The instrument is capital, and the income which 
this capital brings to its owner may be either a money rental 
or the direct shelter and similar benefits of the house enjoyed 
by himself and his family. In either case the income may 
be measured in money, although in the case of occupancy 
by the owner this measurement requires a special appraise- 
ment. The house, let us suppose, was built many years 
ago, and is now nearly worn out. It yields an income worth 
$1000 a year. Against its income there are offsets in the 
form of repairs, taxes, etc. — costs which it occasions. We 
have, then, the following " income account " : — 

INCOME ACCOUNT FOR HOUSE AND LOT DURING THE 

YEAR 1910 

Income Outgo 

Use of house and lot . . $1000 Repairs $200 

Taxes 180 

Insurance 20 

$1000 $400 
Net income .... S600 



60 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

Next year the house is found to have rotten beams, is 
condemned, and must be abandoned or torn down. Its 
benefits are ended, but the land is still good, and the owner 
can build a new house. The period consumed by this opera- 
tion is the first six months of the year 191 1, so that during 
such period there is no income attributable to the house and 
lot, but only outgo. During the second half of the year the 
house is occupied, and its use is valued at $600. In the first 
six months not only did the " house and lot " fail to yield 
any income, but it occasioned a cost. This cost was the 
cost of production of the house. 

We have, then, the following account : — 

INCOME ACCOUNT FOR HOUSE AND LOT DURING THE 

YEAR 1911 

Income Outgo 

Use of house and lot (six Expense of building 

months). . . . . . $600 house $10,000 

Taxes and insurance . 100 

$600 $10,100 

Net outgo . . . . . $9,500 

During this year, then, the house causes a net outgo of 
$9500. As we know, all costs are " necessary evils " ; they 
lead to good, though not good themselves ; and this cost of 
constructing the house was incurred only for the sake of 
expected future benefits. The adverse balance it creates is 
only temporary, and should be more than made up in the 
years which follow. 
For the year 191 2 we have the following : — 

INCOME ACCOUNT FOR HOUSE AND LOT DURING THE 

YEAR 1912 

Income Outgo 

Use $1200 Repairs $ 50 

Taxes and insurance . . 150 
$1200 $200 

Net income $1000 



Sec. 2] INCOME 6 1 

These figures remain about the same for forty-nine years 
and give $49,000 net income during that time, canceling the 
excess in cost for 191 1 ($9500) and leaving a large margin 
besides. Then the house is worn out a second time and has 
to be rebuilt. The same cycle is repeated, one year of ex- 
cess of cost being offset by forty-nine years of excess of in- 
come. 

It will be observed that the cost of reconstructing the 
house was entered in the accounts in exactly the same way 
as the cost of repairing it or as any other costs. This may 
be puzzling at first, because most of the other costs are 
fairly regular year by year, whereas the cost of reconstruc- 
tion occurs only once, or at any rate only once in a long while. 
It may also seem puzzling because the cost of reconstruc- 
tion is so large in comparison with other costs. But the 
irregularity or size of costs is, of itself, no reason for omitting 
them from our accounts. The only way in which we have 
a right to omit such a cost — for instance, the cost of con- 
structing the house — is to avoid it altogether by substitut- 
ing an equivalent series of smaller and more regular costs. 
What is called a depreciation fund is sometimes created for 
this very purpose. This fund is accumulated by setting 
aside annually, throughout the existence of the house, a 
small deposit, sufficient in the aggregate to replace the house 
when it is worn out. The exact nature of such a fund does 
not concern us here. It is sufficient for the present purpose 
to state that the depreciation fund, combined with the 
" house and lot " renders the flow of costs uniform or regu- 
lar. But even when a depreciation fund is used, we can 
only say that the combination of the two things (the fund 
and the house) has a regular cost. We cannot say that this 
is true of the house by itself; and when no such device as a 
depreciation fund at all is used, there can be no escape from 
charging the cost of reconstruction in precisely the same way 
as we charge any other cost. If this still seems puzzling, it 
is because the cost of reconstruction is often entered as the 



62 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

value of the house and, for that reason, called a " capital 
cost." It is true that the value of the new house must be 
entered on the capital-balance sheet; but the cost of pro- 
ducing it belongs properly to the income account. The 
former relates to an instant of time (which may be any 
instant from the time the house is begun till the time when 
it ceases to exist) ; the latter relates to a period of time 
(which may be all or any part of the time during which the 
labor and other sacrifices occasioned by the house occur). 
A house is quite distinct from the series of sacrifices by 
which it was built, although the confusion between the two 
is natural in view of the bookkeeping practice of entering 
capital at its " cost value." The house on which $10,000 
was expended for construction may be worth either more 
or less than $10,000. In either case the income account 
should contain $10,000 on the outgo side, and the capital 
account a larger or smaller figure, as the case may require. 

§ 3. Devices for Making Net Income Regular 

Disturbance of income due to building the house may be 
avoided, not only by a depreciation fund, but by other 
devices; for instance, by paying for the house in install- 
ments ; by borrowing money to defray the cost, and mort- 
gaging the house; or by selling other property. There is 
still another method of steadying income which ought to set 
at rest any further doubt in the student's mind as to the 
propriety of counting the cost of reconstructing a house as 
outgo in the income-accounting. This is by having so many 
houses that the reconstruction of one or another of them 
must occur at short intervals. If a man owns fifty houses,' 
each lasting fifty years, and every year one wears out and 
has to be rebuilt, it is then evident that he will have an 
expense of $10,000 every year for the rebuilding of a house, 
which will be a regular item; and he will have a regular 
income balance as a consequence, because he will get the 



Sec. 4] INCOME 63 

benefit of forty-nine houses, which will far outweigh the cost 
of building only one. The difference will be his net income, 
which will be a fairly regular amount year after year. 

Any large group of wealth involves the same principle. 
Professor Clark of Columbia University suggests a helpful 
simile when he compares a stock or fund of capital to a water- 
fall : the drops of water, or component parts of the water- 
fall or fund, are constantly changing; but the waterfall or 
fund remains substantially the same. 

§ 4. How to Credit and Debit 

Before leaving the subject of income accounts, we shall 
speak of one particular kind of capital, namely, a stock of 
cash. This will furnish an opportunity to illustrate anew 
some of the principles of accounting which we have just dis- 
cussed. What puzzles the novice in accounting is the manner 
of debiting and crediting a stock of cash, or what is called 
the " cash drawer." At first sight the usage seems to be the 
opposite of what it should be. To understand the practice 
of accountants in this particular is to go a long way toward 
understanding the main principles of accounting. It will 
help us to understand it if we liken a cash drawer to a gold 
mine. We credit a gold mine with all the gold extracted, 
and we debit it with all the costs put into it. In the case of 
the gold mine, what it costs to run it is outgo ; all of the 
yield of gold is gross income ; and the difference is the net 
income. Similarly, the gross income from the cash drawer 
consists of what the cash drawer yields, or whatever comes 
out of it. It benefits us whenever it pays our bills ; it costs 
us whenever we pay its bills, i.e., whenever we pay some- 
thing into it. All the payments which we have to make to 
the drawer are a cost of that drawer to us, whereas all the 
payments that we make by the drawer are the benefits which 
it produces for us. As long as we pay money into the drawer, 
we realize no income, but merely accumulate capital for 



64 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

future use. If we should only pay money into the drawer and 
never throughout our life take any out, the "drawer " would 
benefit us nothing. Its benefits would go to our descendants 
whenever they should take the money out. Ordinarily, 
however, the money is taken out soon after it is put in. What 
net benefit, then, does the cash drawer yield in the long run ? 
Seldom anything at all. We pay out just as much as we 
put in ; and if we subtract one amount from the other, the 
net annual income from the cash drawer will be about zero, 
unless during a certain year we store up more than we take 
out, or take out more than we put in. 

The reason that these credits and debits of " cash " seem 
at first the reverse of what they should be is that we are ac- 
customed to think of money receipts and expenditures, not 
in their relation to the stock of cash into or out of which they 
are paid, but in their relation to some other item of wealth 
on account of which the payments are made. If a lodging- 
house keeper receives $10 from a lodger and puts it into her 
cash drawer, she finds it hard to debit $10 to " cash." She 
thinks of the $10 as income ; and it is income with respect to 
her lodging-house, for the latter has yielded it to her. Her 
stock of cash, however, has not yielded the $10 to her. On 
the contrary, it has taken that amount from her. Later on 
it will yield back that amount or some portion of it, and at 
that time may properly be credited with the sum it yields up. 

We are now ready to understand how to derive a man's 
total income. It is simply the combined income from all 
the capital he owns. We could obtain a full account of it by 
keeping a separate income account for each item of capital 
he owns, crediting and debiting each such item with its re- 
spective benefits and costs. The difference of all the benefits 
and costs of all his capital is his net income. In these 
accounts we should include, therefore, all positive and nega- 
tive items of income pertaining to all positive and nega- 
tive items of capital. The negative items of capital are 
the liabilities. Liabilities yield a net outgo instead of a 



Sec. 4] INCOME 65 

net income. In order, then, to find out the net income of 
any person during a certain day or month or year, the 
proper method is to make a complete statement of all his 
assets and all his liabilities ; and for each asset as well as 
each liability, credit all the benefits and debit all the costs. 
The net result will be the net income of the person. 

A real person will have a net income, but a fictitious 
person will not. We have seen, in the case of fictitious per- 
sons, that there is no net capital because the liabilities always 
equal the assets ; for what is called the capital of a " com- 
pany " really means the capital of its stockholders. As 
there is no net capital of the company, as such, the " com- 
pany " owing it all to the stockholders, so there is no net 
income of the company, as such, the " company " paying 
it all to the stockholders or others. 

The following is an imaginary income account of a rail- 
road company : — 



INCOME ACCOUNT OF A 


RAILROAD CORPORATION 


Income 


Outgo 




By passenger and 


To operating expenses 


$800,000 


freight service . $1,246,147 


To interest to bond- 






holders .... 


100,000 




To dividends to stock- 






holders .... 


200,000 




To surplus applied to 






(1) purchase of land 


140,000 




(2) cash paid into 






treasury . . . 


6,147 



$1,246,147 $1,246,147 

The passenger and freight service yields $1,246,147. That 
is the gross income of the road. All the benefits flowing 
from that road are worth this amount of money. On the 
other side of the railroad account we find the costs of the 
road to the company ; they exactly equal the benefits, for 
the company is an abstraction — a mere holding concern — 



66 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

not a real individual. The outgo consists principally of 
operating expenses, $800,000; interest to bondholders, 
$100,000 ; dividends to stockholders, $200,000. The words 
by and to are usual in income accounts. The receipts are 
benefits ; they come by virtue of the services designated. 
The costs represent something which has to be given to 
these several items in order to make the benefits possible. 
These items leave a surplus, part of which is expended for 
land ($140,000) ; this is a cost just as much as anything 
else. Then there is cash left in the treasury to the amount 
of $6147. It must not be concluded that this cash is a net 
income. The cash drawer swallows it up. The company 
loses $6147, so to speak, in feeding its cash drawer. There- 
fore the two sides of the account balance, and there is no 
net income at all to the " company." 

§ 5. Omissions and Errors in Practice 

Practically, however, it is not convenient to enter in an 
income or a capital account everything which theoretically 
ought to be entered there. Moreover, capital and income 
accounts are not always treated consistently in practice. 
For instance, in. a capital account a man would not enter 
his own person, as a free human being is not ordinarily 
counted as wealth; and yet in his income account he will 
enter the money he earns or the work that he does. That 
is, work and wages are entered in the income accounts, but 
the corresponding items which do this work or earn these 
wages are not entered in the capital accounts. The corre- 
spondence between the two accounts is therefore obscured. 
On the other hand, a man never enters in bis income account 
the shelter of his own house as a benefit, and yet he may 
include the house among his assets in his capital account. 
In ideal accounting we should insist upon recording every 
benefit of any kind, every cost, and every source of benefit 
or cost. As we have already indicated, an early economist 



Sec. 5] INCOME 67 

fell into error when he said that a dwelling occupied by the 
owner yields no income. He claimed that, on the contrary, 
it is a source of expense. Evidently he had in mind only 
those costs and benefits which come in the form of money 
payments. We certainly get no money benefits by living in 
our house, while we do suffer a money cost to run it. So far 
as money receipts and expenditures are concerned, therefore, 
the house costs more than it brings in. But no man would 
keep his house if it did not afford him benefits greater than 
its costs. We should therefore appraise the shelter of the 
house and enter this as its gross income. The absurdity 
of not counting the shelter of a house as income is particularly 
apparent if we note that this same economist, like all other 
economists, includes under income the rent or money in- 
come that the owner gets from a house which is rented. 
This economist would have said that a man who enjoys 
shelter gets no income, but that if he gets paid for the shelter 
enjoyed by another man, he does get income. This results 
in the absurd conclusion that if I live in my own house and 
you live in your own house, neither of us receives any income ; 
but if you rent your house to me and I rent mine to you, 
then we shall each be receiving income ! Obviously the 
income is really there, all the time, in the form of shelter ; 
and when one man rents another man's house, he gets the 
shelter-income and gives the other man a money-income in 
its place. 

An account of money received and expended by a given 
person can sometimes furnish a fairly complete picture of 
his income ; but only when two conditions exist ; namely, 
that all the income is in the form of money, and all the outgo 
is for personal satisfactions (i.e., goes directly to pay for 
clothes, food, shelter, amusements, and the like, and is not 
expended in investments, repairs, and the expenses of run- 
ning a business). Under these conditions the cash drawer 
and the cash account constitute a kind of money meter of 
income. These conditions are approximately fulfilled when 



68 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

people live in a city and rent their houses or furniture 
instead of owning them. Such people get practically all of 
their income in the form of money receipts, as salaries, 
dividends, and interest. This money is spent for benefits, 
as food, clothing, theater going, etc. These operations are 
essentially all that occur in the case of such people. The 
cash drawer (or bank account) then intervenes between the 
money-income — the receipts of salaries, dividends, and 
interest — on the one hand, and the final form into which 
this money-income is converted by expenditure, on the 
other hand; much as a cogwheel intervenes to transmit 
motion from one part of a machine to another. In strict 
accounting, the bank or drawer should be debited with all 
the money flowing into it from salaries, stocks, and bonds, 
and credited with all the expenditures. But these opposite 
sums approximately offset and so cancel each other. 

The only method, then, of constructing income and outgo 
accounts which will be correct and which can serve as a basis 
for economic analysis is the method already indicated — 
the method by which are recorded, for each article of capital, 
the values of all its benefits and all its costs. These benefits 
and costs are of many kinds. Sometimes they consist of 
money payments — not in themselves enjoyable to anybody ; 
sometimes they consist of merely productive operations; 
and sometimes, of truly enjoyable elements. All these 
items should be entered in the accounts on the same footing ; 
but we shall see that after being thus entered they may be 
so combined that all except the " enjoyable " elements will 
cancel among themselves. 



CHAPTER V 



ADDITION OF INCOME 



§ i. Methods of "Balances" and " Couples " 
" Interactions " 

We have now learned how to reckon the income of either 
a real or a fictitious person. Of reckoning the income of all 
society, on the other hand, there are many ways, including, 
in particular, two that correspond to the two ways which we 
discussed in Chapter III of reckoning society's capital; 
that is, the method of balances and the method of couples. 
The method of balances is very easy to understand. All 
that is necessary is to make up an income account for any 
given period for each instrument or article of wealth so as 
to include all possible income or outgo in the society under 
consideration, and, deriving from each individual account 
the net balance, add these net results together. The result 
is the total income of society. Its constituent parts are 
the net incomes from the several articles of society's wealth. 

The " method of couples " is somewhat more difficult to 
follow. But it is also more important. Just as it often 
happens that the same item in capital accounts is both asset 
and liability, according to the point of view, and is therefore 
self-canceling, so it often happens that the same item in 
income accounts is both benefit and cost, and is, therefore, 
likewise self-canceling. In fact, the reader may have felt 
that, in many of the examples cited, what we called costs 
were really benefits. He may have asked himself : Why 

69 



70 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

should we call repairing a house a cost ? When a carpenter 
and his tools repair it, do we not credit him and them with 
a service performed? Is not any production a benefit? 
Have we not, then, placed repairs on the wrong side of the 
ledger ? It all depends upon which of two accounts we are 
considering. When a carpenter with his plane, hammer, and 
saw helps to rebuild a house, we have to consider two groups 
of capital. One group, the carpenter and tools, is acting On 
the other group, the house. The carpenter and tools cer- 
tainly perform a service or benefit, but the house does not. 
Considered as occasioned by the house, the repairs are costs. 
The house absorbs or soaks up these costs, promising to com- 
pensate for them by benefits to be yielded later on. The 
renailing of loose shingles is certainly not what the house is 
for ; with respect to the house, it is a necessary evil ; with 
respect to the hammer, however, it is a service rendered. 
Therefore the repairing of the house is at once a benefit and 
a cost. 

Such double-faced events are so important as to require a 
special name. We shall call them interactions. Each inter- 
action takes place between two instruments or groups of 
instruments. 

An interaction, then, is a double-faced event, at once a bene- 
fit or service of the acting instrument, and a cost or disserv- 
ice of the instrument acted on. There can never arise the 
slightest doubt as to when it is to be regarded as positive and 
when negative. The definitions of benefit and cost settle 
this question in each case by referring it to the desire of the 
owner. Since the house owner desires that the house should 
not occasion repairs, these repairs are costs of the house; 
and since he desires that the tools should produce repairs, 
such repairs are the benefits of those tools. 

The example given is typical of the general relations be- 
tween interacting instruments. The mental picture we 
should construct is that of two distinct groups of capital. 
Group A acts on, and, so to speak, benefits Group B. What- 



Sec. 2] ADDITION OF INCOME 7 1 

ever the nature of this interaction, A is credited with it as a 
benefit, and B is debited with it as a cost. These two items 
of credit and debit are equal and simultaneous because they 
are the selfsame event looked at from opposite sides. 

Interactions constitute the great majority of the elements 
which enter into income and outgo accounts. The only 
benefits which do not form merely the positive side of such 
canceling interactions, and so do not cancel out, are satis- 
factions — desirable conscious experiences — often called 
"consumption^'; and the only costs which do not form 
merely the negative side of such canceling interactions, and 
so do not cancel out, are " labor and trouble." But these 
two final elements — " satisfactions," on the one hand, and 
"labor and trouble," on the other — are only the outer 
edges of the series of interactions. Between them lies a 
connective chain of productive processes and commercial 
transactions, every link of which has two sides, a positive 
side of benefits or services and a negative side of costs, 
always mutually canceling. 

§ 2. Production : Interactions which Change the Form of 

Wealth 

The interactions between two articles or groups of articles 
are of three chief kinds : changes in the form of wealth, 
changes in the position of wealth, and changes in the owner- 
ship of wealth ; in other words, transformation, transporta- 
tion, and transfer or exchange. All three may be called 
"production," although this term is sometimes confined to 
the first two and sometimes even to the first alone. These 
we shall take up in order, and show how each is a two- 
faced event or an interaction. 

First, what is here called " transformation " of wealth is 
practically identical with what is usually understood by 
" production " or " productive processes." By this trans- 
formation or change in the form of wealth is meant the 



72 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

change of relative position of its parts. Weaving, for 
instance, is the transformation of yarn into cloth by a re- 
arrangement in the relative positions of the warp and woof. 
Spinning, likewise, consists of moving, stretching, and twist- 
ing fibers into yarn ; sewing, of changing the position of 
thread so that it may hold cloth together; and so it is 
with carding, wool sorting, shearing, and all the other 
operations which constitute the manufacture of fabrics. 
All these operations — in fact, all manufacture and all 
agriculture — consist simply of a series of transformations 
of wealth, each transformation being a two-faced operation. 
With respect to the transformed instrument or instruments, 
the transformation is a cost ; with respect to the transform- 
ing instrument or instruments it is a benefit. So it is 
when a loom produces cloth out of yarn, or when land 
renders a service in producing wheat. So it is, not only 
when a carpenter and his tools build or repair a house, 
but also when the painter decorates it or the janitor 
cleans it ; or when a cobbler transforms leather into shoes, 
or when a bootblack transforms dirty shoes into clean and 
polished ones. 

The principle is not altered when the interaction consists, 
not in producing a change, but in preventing one. A ware- 
house renders its service as a means of storing bales of cotton, 
i.e., protecting them from the elements ; and this storage is, 
on the part of the stock of cotton, an element of outgo, or 
expense, as on the part of the warehouse it is an item of in- 
come. 

Nor is the principle altered when there are, as indeed is 
usually the case, more articles than one in either or both of 
the two interacting capitals. Plowing, or the transformation 
of land into a furrowed form, is performed by a plow, a 
horse, and a man. The plowing is a cost debited to the land, 
on the one hand, and at the same time a service credited to 
the group consisting of the plow, horse, and man, on the 
other. 



Sec. 3] ADDITION OF INCOME 73 

Nor is the principle altered if one or more of the trans- 
forming agents perish in the transformation and another 
comes for the first time into existence. Bread making is a 
transformation debited to the bread and credited to the cook, 
the range, the flour, and the fuel, of which the last two are con- 
sumed as soon as they perform their services. Agents which 
disappear in the transformation, but reappear in whole or 
in part in the product, are called " raw materials." The 
production of cloth from yarn is a transformation effected 
by means not only of the loom, but also of a number of other 
agents, among them the yarn itself, which thus vanishes 
as yarn and reappears as cloth. The cost of weaving in- 
cludes the consumption of raw material — yarn ; and this 
consumption of yarn is, on the part of the yarn itself, not 
cost, but service. It is the use for which the yarn existed. 
When cloth is turned into clothes, this transformation is a 
service to be credited to the cloth, and a cost to be debited 
to the clothes. All raw materials yield benefits as they 
are converted into finished products. Their conversion is, 
however, on the part of these products, always outgo and 
not income. 

In general, production consists of a succession of stages, 
and at each stage there is an interaction. The finished 
product of one stage passes over as the raw material of the 
next, and its passage from the earlier to the later stage is an 
interaction between the capitals of the two. 

§ 3. Transportation : Interactions which Change the Posi- 
tion of Wealth 

The second class of interactions we have called " trans- 
portation." It is a very slight distinction which separates 
this class from the preceding class. Transforming or pro- 
ducing wealth consists in changing the position of its parts 
as related to one another ; transporting wealth consists in 
changing the position of that wealth as a whole. But 



74 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

" part " and " whole " are themselves loose and relative 
terms. Bookbinding is a transformation or production of 
wealth ; it assembles the paper, leather, thread, and paste 
into a whole book. Delivering the finished book to a 
library is transportation. Yet the library is, in a sense, a 
whole ; and to assemble books into a classified and organized 
library is to make a whole out of parts. The distinction 
between transformation and transportation is thus merely 
one of convenience. Many writers prefer to include them 
both under " production." We prefer to include them under 
the less ambiguous and more inclusive head of " inter- 
actions," and our object here is not to emphasize their 
difference but their similarity. The principles already 
discussed of coupling and canceling equal and opposite 
items apply also to transportation. The following are 
examples. When merchandise is transmitted from one 
warehouse to another, the stock in the first warehouse is 
credited with the change and that in the second, debited. 
The stock which has rendered up the merchandise has done 
a service; that which has received it is charged with a 
cost. A banker who takes money from his vault and puts 
it into his till will, if he keeps separate accounts for the 
two, credit the vault and debit the till. When wheat is 
imported from Canada, that nation is credited, and the 
United States is debited, with the value of the wheat. 

§ 4. Exchange : Interactions which Change the Ownership 
of Wealth 

The third class of interactions is the change of ownership 
of wealth or of property. This has been called "transfer." 
Every transfer is a species of interaction. If money is 
transferred from Smith's cash drawer to Jones's, Smith's 
cash drawer is credited with the sum yielded up, and Jones's 
is debited with receipt of the same. Transfers usually occur 
in pairs, and involve two objects transferred in opposite 



Sec. 4] ADDITION OF DNCOME 75 

directions between two owners. One transfer pertains to 
each object. Such a double transfer we have called an 
exchange. Since an exchange consists of two transfers, and 
since a transfer is a species of interaction and as such is self- 
canceling, every exchange is self-canceling, and hence cannot 
of itself affect the total income of society (although it may 
lead to later items which are not self -canceling) . What- 
ever is credited on one side is debited on the other. We 
see, then, that an exchange, whether of goods against goods 
or of goods against money, occasions an element of income 
to the seller equal to the corresponding element of outgo 
to the purchaser, and an element of outgo to the seller equal 
to the corresponding element of income to the purchaser, 
and therefore no immediate income at all to society. 

The effect of canceling these items — the credit item of 
the seller and the debit item of the purchaser — is to free 
the income account for any article from all entanglements 
with exchange, to wipe out all money-income, and to leave 
exposed to view the natural or final income from that 
article. Thus books yield their natural income, not when 
the book dealer sells them, but later when the reader 
peruses them. The sale is a mere preparatory service, a 
credit item to the book dealer, and a debit item to the 
buyer. Again, a forest of trees yields no natural income 
until the trees are felled and pass into the next stage of logs. 
The owner of the forest may, to be sure, " realize " on the 
forest long before it is ready to be cut, by simply selling it to 
another. To the seller the forest has then yielded income ; 
but, as the purchaser has suffered an equal outgo, the net 
result of this interaction, as of every other, is zero. Simi- 
larly, the money " rent " of a rented house is, for society, 
not income at all. It is income to the landlord, but outgo 
to the tenant — outgo which he is willing to suffer solely 
because of the shelter he receives. As we may cancel the 
landlord's money-income against the tenant's money-outgo, 
it is clear that the shelter alone remains as the income from 



76 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

the house. The shelter-income is the essential and abiding 
item, and without it there could be no rent-income to the 
landlord. Thus we see clearly the fallacy of the old view 
that a dwelling yields income only when it is rented. In 
like manner, a railway yields as its natural income solely 
the transporting of goods and passengers. Its owners sell 
this transportation service for money, and regard the rail- 
way simply as a money-maker ; but to the shippers and pas- 
sengers this same money is an expense, and exactly offsets 
the railway's money earnings. Of the three items — 
money-income of the road, money-outgo of its patrons, and 
transportation — the first two mutually cancel and leave only 
the third, transportation, as the real contribution of the 
railway to the sum total of income. 

We do not mean, of course, that interactions are useless, 
but simply that in the accounting of society they are self- 
canceling. They are a necessary step toward achieving the 
final income which remains uncanceled, but they themselves 
disappear under the method of couples. This method, 
applied to buyer and seller, denudes all capital of its so- 
called " money-income," and lays bare the only income it 
can naturally produce. We see that capital is not a money- 
making machine, but that its income to society is simply its 
services of production, transportation, and gratification. 
The income from the farm is the yielding of its crops; 
from the mine, the giving up of its ore ; from the factory, 
its transformation of raw into finished products; from 
commercial capital, the passage of goods between producer 
and consumer ; from articles in consumers' hands, their en- 
joyment or so-called " consumption." 

Similar principles apply to outgo, no part of which, for 
society, occurs in money form. The great bulk of what 
merchants call " cost of production," expense, or outgo, 
consists of money costs which, as concerns society, carry with 
them their own cancellation, and so are not ultimate costs 
at all. For manufacturers, merchants, and other business 



Sec. 5] ADDITION OF INCOME 77 

men, almost every outgo is an expense, i.e., consists of a 
money payment. But such money payments are for 
wages, raw materials, rent, and interest charges, all of which 
are incomes for other people. The wages are the earnings 
of labor ; the payment for raw material is received by some 
other manufacturer, farmer, or miner ; the rent is received 
by the landlord ; the interest charges, by the creditor. 

§ 5. Accounts Illustrative of Interactions in Production 

Not only do exchange transactions completely cancel them- 
selves out in reckoning the total income of society, but the 
great majority even of the natural benefits of capital do the 
same. Even these natural benefits of capital consist for 
the most part of " interactions " ; they are transformations 
or transportations of wealth. They are intermediate stages, 
merely preparatory to the final enjoyable benefits of wealth, 
and, after the interactions have been canceled out, do not 
enter as items either on the income or the outgo side of the 
social balance sheet. In order to show the effect of cancel- 
ing out the equal and opposite items entering into every 
interaction throughout all productive processes, let us ob- 
serve the various stages of production which begin with the 
forest above referred to. The gross income produced by 
the forest is the series of events called the turning out of 
logs. This log production is a mere preparatory service, a 
credit item to the forest and a debit item to the stock of 
logs of the sawmill, to which the logs next pass. As the 
sawmill turns its logs into lumber, the lumber yard is 
debited with the production of lumber, and the sawmill is 
credited with its share in this transformation. Intermedi- 
ate categories may, of course, be created, and we may 
follow, in like manner, the further transformation, transpor- 
tation, and exchange to the end of the stages of produc- 
tion — or rather, to the ends ; for these stages split up and 
form several streams flowing in different directions. To 



78 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. V 

follow one of these streams, let us suppose that the lumber 
which goes out from the yard is used in repairing a certain 
warehouse. The warehouse is used for storing cloth ; the 
cloth goes from the warehouse to the tailor ; the tailor con- 
verts the cloth into suits for his customers ; and his custo- 
mers receive and wear those suits. In this series of 
productive services, all the intermediate services cancel 
out in " couples " and leave as the only uncanceled ele- 
ment, or fringe of final services, the use of clothes in the 
consumers' possession. 

Should we stop our accounts, however, at earlier points in 
the series, the uncanceled fringe at which we should find 
ourselves would be some other item. The uncanceled in- 
come item in a production series is always the positive side 
of some intermediate service or interaction whose negative 
side does not appear, as it belongs to a later stage in the 
series. This will be clear if we put the matter in figures, 
stage by stage. The following are the items for the logging 
camp above mentioned, in the accounts of its owner. 

INCOME ACCOUNT FOR LOGGING GAMP 



Income 


Outgo 


Yielding of logs to sawmill . $50,000 


(Omitted) 



The gross income from the logging camp, considered by 
itself, and without any deductions for expenses, is here seen 
to consist in the production of $50,000 worth of logs. If, 
however, we now combine the account of the logging 
camp with that of the sawmill, we shall have accounts like 
the following, in which, to avoid irrelevant complica- 
tions, no mention is made of any expenses which do not 
happen to be interactions between the groups of capital 
considered : — 



Sec. 5] 



ADDITION OF INCOME 



79 



INCOME ACCOUNT FOR LOGGING CAMP AND SAW- 
MILL 



Capital Source 


Income 


Outgo 


Logging camp . . . 


Yielding logs to saw- 
mill . . . $50,000 
Yielding lumber to 
lumber yard $60,000 


(Omitted) 

Receiving logs from 
camp . . $50,000 



In this case, canceling the two log items of $50,000 each, 
we have left only the lumber item ; that is, the net income 
from the combined logging camp and sawmill consists only 
of the production of lumber, their final product. The 
transfer of logs from one department to the other no longer 
appears. This transfer is like the taking of money from 
one pocket and putting it into another — a fact which 
would be particularly evident in case the logging camp and 
sawmill were combined under the same management. 

Extending the same principles to the entire series, we have 
the accounts as given in the table on the following page. 

In this table we may successively cancel each pair of 
items constituting an interaction. An item on the left is 
the positive side of an interaction of which the item on the 
right in the line next below is the negative side. Thus, as 
previously, the $50,000 in the first line on the left cancels the 
$50,000 in the second line on the right. Similarly, the two 
items of $60,000 cancel in the two lines next below, to the 
right and left, respectively. If we stop after the first two 
cancellations, thus restricting the account to the first three 
horizontal lines of the table, we shall find that the net in- 
come from logging camp, sawmill, and lumber yard consists 
only of the production of retail lumber, worth $70,000 ; it 
includes neither the transfer of logs from the camp to the mill 
nor the transfer of lumber from the mill to the yard. In 
like manner, if we proceed one stage further, i.e., if we stop 



8o 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 



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Sec. 6] ADDITION OF INCOME 8l 

our cancellations at the end of the first three interactions, 
the production of retail lumber no longer appears as an ele- 
ment of income ; and so on, step by step to the end, when the 
only surviving item will be the " wear " of the suits. 

It is, of course, true that in any actual accounts there will 
be other items besides those which have been exhibited in 
this simple, chainlike fashion. Were it worth while, we 
might insert these additional entries of income and outgo 
elements. Most of them would likewise consist of the posi- 
tive or the negative side of interactions ; and if we were to 
introduce their respective mates, the opposite aspects of the 
same interactions, it would be necessary to include the 
accounts of still other instruments. If we should follow 
up all such leads, we should soon have, instead of the simple 
chain represented in the table, an intricate network of re- 
lated accounts ; but the same principle of the interaction as 
a self-effacing element would continue to apply. 

§ 6. Preliminary Results of Combining these Income 

Accounts 

The table given will throw light on the question : Of 
what does income consist? or, to be more definite: Of 
what does the income from a particular group oj capital- 
goods consist ? Whether the production of logs is income or 
not depends upon the point of view. It is income with re- 
spect to the first link of capital in our series (the logging 
camp) ; it is not income with respect to the first two links 
taken together, for in the second link it occurs as outgo. 
Likewise the use of the warehouse is income with respect to 
the first four links of capital, but is not income with respect to 
the first five links. 

We see, therefore, that in reckoning up the income from 
any group of capital we may as well omit all interactions 
taking place within it, and confine ourselves to the outer 
fringe of services performed by the group as a whole. As 



82 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 



the group is enlarged, this particular outer fringe disappears 
by being joined to the next part of the economic fabric, and 
another fringe still more remote appears. 

Contrasting the method of couples with the method of 
balances, we may say that the method of couples is useful 
in showing of what elements income consists in any given 
case. The method of balances, on the other hand, is useful 
in exhibiting the amount of income contributed from each 
capital source. The two methods, as applied to the example 
just given, are as follows : — 

METHOD OF BALANCES 



Capital Income 


Outgo 


Net Income 


Stock of cloth in warehouse 90,000 
Stock of cloth of tailor . . 500,000 
Stock of clothes of customers 600,000 


(Omitted) 
$ 50,000 
60,000 
70,000 
80,000 
90,000 
500,000 


$ 50,000 
10,000 
10,600 
10,000 
10,000 
410,000 
100,000 


1 


$ 600,000 



METHOD OF COUPLES 
(Summary of Table on p. 80) 



Income 



Outgo 




Sec. 6] ADDITION OF INCOME 83 

The two methods — balances and couples — show the 
same result, but from different points of view. By means 
of the method of balances we are enabled to see what part of 
the final net income is contributed by each of the articles in 
the group. By means of the method of couples, we are en- 
abled to see of what the net income from the entire group of 
articles consists; canceling by the oblique lines, we have 
left but one item, $600,000, representing the u wear" of 
the suits. 

The two methods must not be confused. When we find 
by the method of couples that the net income of $600,000 
consists exclusively of the use of suits of clothes, this does 
not by any means imply that this net income is all of it due 
to the stock of clothes. To discover to what kinds of capital 
it is due, recourse must be had to the method of balances. 
We then see that only $100,000 of it is due to the stock of 
clothes, the remainder being due to the other capital instru- 
ments in the table, which made the clothes possible, and most 
of all ($410,000) to the tailor's stock of cloth. Combining 
the results of both methods, we may state that the total net 
income from the specified group of instruments consists of 
$600,000 worth of "wear " of suits, and that this is due partly 
to the stock of clothes and partly to other capital. Of course 
our table does not give all the capital to which the wear of 
the suits is indebted. We have, as already noted, omitted, 
for the sake of simplicity, all items of cost which do not 
belong to our chosen series. But the inclusion of other 
items, while it complicates the accounts, does not change 
the principle of cancellation. It merely introduces other 
chains of interactions. 

The two methods correspond in a general way to the two 
methods for canceling liabilities and assets in capital ac- 
counts. The method of balances gave, it will be remem- 
bered, the amount of capital belonging to each individual ; 
the method of couples showed of what elements the total 
capital consists. 



84 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. V 

§ 7. Double Entry in Accounts of Fictitious Persons 

We have now followed the cancellations to which inter- 
actions lead, whether they be interactions of exchange or of 
production. The case of exchange, however, needs further 
consideration. Since every exchange consists of two trans- 
fers, and every transfer of two items, a credit and a debit, 
the exchange evidently consists of four items in all, two of 
which are credits and two of which are debits. These four 
may be paired off in two ways, only one of which has thus far 
been mentioned. They stand, as it were, at the four corners 
of a square, as in the following scheme, which shows the 
credits and debits involved when goods worth $2 are sold. 
The dealer credits his stock of goods and debits his " cash," 
while the buyer does the opposite. 





Stock of Goods 


Stock of Cash 




+ $2 


-$2 




-$2 


■ +$2 



The two transfers into which any exchange may be re- 
solved are represented by the second and third columns of 
the table. The former indicates that one kind of goods has 
been transferred from the stock of the seller to that of the 
buyer; the latter, that another kind of goods (money) 
has been transferred from the stock of the buyer to that of the 
seller. But an exchange may also be resolved into two pairs 
of items represented by the two horizontal lines of the table. 
The items in the same horizontal line record the part taken 
in the exchange by one of the two persons participating in it. 

Every exchange, then, consists of four items, and may be 
resolved either into two transfers (one for each good ex- 
changed) or into two transactions (one for each person 
exchanging those goods). 



Sec. 7] 



ADDITION OF INCOME 



85 



These latter items, namely, transactions represented by 
the horizontal lines, we must now consider more fully. 
All the previous income accounts are accounts of income 
flowing from instruments or property, not of income enjoyed 
by persons. But it is easy now to form the income accounts, 
i.e., of the income and outgo of all assets and liabilities, of 
persons, simply by combining in each case, by the method 
of balances, the accounts of all the items of property (whether 
assets or liabilities) of any given person. We must distin- 
guish, however, the accounts of real and of fictitious persons. 
We begin with the income account of a fictitious person. 

The following account represents the entries during a given 
year for a dry goods company. In this account we observe 
that every item on the income side is balanced by an equal 
and opposite item on the outgo side. All items thus paid 
are represented by the same letters, the capitals being 
used for positive items and the small letters for negative. 



INCOME AND OUTGO OF DRY GOODS COMPANY 
FOR 1910 



Capital Source 


Income 


Outgo 


Stock of goods 


By goods sold $10,000 A To goods bought $5,000 b 


Cash .... 


By cash taken out for: To cash received from 
Purchases $5,000 B sales . . . $10,000 a 
Profits paid $2,000 C j 


Capital Stock . 
(a liability) 




To profits paid $2,000 c 



The rule we have learned in Chapter IV for making com- 
plete income accounts is to start with the capital account, 
taking each item of assets and each item of liabilities, and to 
enter for each item of either kind all the items of income to 
which they give rise, plus or minus, as the case may be. 



86 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

For simplicity, it is here assumed that, instead of fifty or one 
hundred different items of capital, there are only three items ; 
namely, the stock of goods, the stock of cash, and the " capi- 
tal stock," which is a liability item. The stock of goods 
yields $10,000 worth of sales. But, on the other hand, it 
costs $5000 to replenish this stock of goods. Therefore it is 
credited with a plus item of $10,000, and debited with a 
minus item of $5000. The student will notice, moreover, 
that each of these items is entered twice, once on each side. 
The doubly entered items may be mutually canceled. A 
cancels with a ; that is, though the stock of goods is credited 
with bringing in $10,000 (A) in cash, the cash drawer must 
be debited with the $10,000 (a) which it swallows up. Like- 
wise the stock of goods costs $5000 (b), which must therefore 
be debited to it ; but the cash drawer has to supply this 
$5000, and is therefore credited with $5000 (B), so that item 
B cancels with b. Finally, when the profits are paid, they 
also come out of the cash drawer, and the cash drawer is 
credited with exactly that amount, $2000 (C) ; while the 
" capital stock " is debited with that amount as a cost (c). 
So we see that all six items cancel one another in pairs. 
The two sides of the account of such a fictitious person 
necessarily balance. Even if the company accumulates its 
profit instead of paying it to the shareholders, the two sides 
of its account still balance; for, as has been seen, all 
money received is not only credited to the capital source 
which brought it in, but is also debited to the cash account. 

§8. Double Entry in Accounts of Real Persons 

In the case of real persons, however, the two sides do not 
balance, for the accounts do not then consist solely of double 
entries. To show this, let us consider the accounts of a 
real person as given in the next table. In these accounts, as 
in the previous ones, both of which are much simplified, 
we have indicated the like items on opposite sides by like 



Sec. 8] 



ADDITION OF INCOME 



87 



letters, the positive items being represented by capitals and 
the negative by small letters. We observe that, as in the 
accounts of the previous company, many of the items will 
" pair." But, unlike the company's accounts, the present 
accounts contain a residue of items which will not pair. 
The letters representing these unpaired items are designated 
by being inclosed in square brackets. They show that [B] 
and [C] — the shelter of the house, and the use of food — 
constitute a kind of income which does not appear else- 
where as outgo. 

INCOME AND OUTGO OF A REAL PERSON FOR THE 
YEAR 1910 



Capital Source 


Income 


Outgo 


Stocks and bonds 


By receipt of money from 


To money expended 




stocks and bonds $2000 A 


for stocks and 
bonds . $500 d 


Lease right . . 


By shelter . . . $100 [B] 


To money rent 
paid . . Sioo 1 


Food . . . . 


By use of food . . $150 [C] 


To money cost of 
food . . $150 / 


"Cash" . . . 


By cash taken out for 


To receipt of money 




stocks and bonds $500 D 


from stocks and 
bonds . $2000 a 




By payment for rent $100 E 


To receipt of 
money for work 
done . $2000 g 




By payment for food $150 F 




Self 


By receipt of money for work 
done . . . . S 2000 G 





Uncanceled items : Shelter [B] . . $100 

Use of food [C] . $150 

Total uncanceled income .... $250 



88 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

When studying the accounts of instruments, we found in 
considering the chain of productive services of a lumber 
camp, etc., that there always remains some outer fringe of 
uncanceled income. We have now reached this same kind 
of outer fringe in studying the accounts of persons, provided 
they are real persons. This outer fringe consists of the 
final benefits of their instruments. All other items are 
merely interactions preparatory to such final benefits, and 
pass from one category of capital to another. Thus the in- 
come from investments, being paid into the cash drawer, is 
outgo with respect to the cash drawer ; this yields income 
by paying for stocks and bonds, food, etc., but in each case 
the same item enters as outgo with respect to these or other 
categories of capital. In all these cases the individual re- 
ceives no income which is not at the same time outgo. It 
is only as he receives shelter from the house, consumes food, 
wears clothes, or uses furniture, or some other article, that 
he receives income. And these final benefits are, of course, 
the end and goal of all the preceding economic processes and 
activities. 

We have thus reached what may be called the stage of 
final or enjoyable income. This is the stage at which wealth 
at last acts upon the person of the recipient. This final 
objective income is that of which the economist is in search, 
and is that which the ordinary statistics of workingmen's 
expenditures represent. It has been made clear that, in the 
final net income which we derive from wealth, all interactions 
between different articles of wealth drop out — all the trans- 
formations of production, such as the operations of mining, 
agriculture, and industry, all the operations of transportation, 
and all business transactions or exchanges. For in all such 
cases the debits and credits inevitably occur in pairs of equal 
and opposite items. Each pair consists of the opposite facets 
of the same interaction. The only items which survive are 
the final personal uses of wealth. The chief classes of such 
uses or benefits are those from food, housing, and clothing. 



Sec. 9] ADDITION OF INCOME 89 

As students of economics, we may stop at this point, 
although, theoretically, there is one step more before the 
process is complete. Indeed, no benefits outside ourselves 
are of significance to us except as they lead to feelings 
within our minds. And if we regard the human body in 
the same light in which we have regarded articles of 
wealth, we could extend our accounts by conceiving wealth 
as interacting with the human body. We would then 
debit the human body with the nourishment, shelter, pro- 
tection from cold, etc., which it receives from food, dwellings, 
clothing, etc., and credit it with the satisfactions experienced 
through the brain, i.e., the feelings of enjoyment of food or 
avoidance of pain, etc. As, however, we have limited the 
concept of wealth to objects external to ourselves and have 
excluded free human beings, we shall not attempt to follow 
these transformations of income after they reach the per- 
son of the owner. Usually the mental satisfactions follow 
so closely after the physical effects of wealth on the human 
body that practically we scarcely need to distinguish be- 
tween those physical effects and the resulting satisfactions. 
Hereafter we shall speak of satisfactions of food, shelter, 
clothing, etc., as if they flowed directly from these external 
objects. 

§ 9. Ultimate Costs and Income 

We have now reached a convenient place at which to 
emphasize a point of great importance, but one which is 
seldom understood; namely, that most of what is called 
" cost of production " is, in the last analysis, not cost at all. 
We have found, in using the method of couples, that every 
item of cost is also an item of income, and that in the final 
total no such items suroive cancellation. It costs the baker 
flour to produce bread ; but the cost of flour to the baker 
is a benefit to the miller. To society as a whole, on the 
other hand, it is neither cost nor benefit, but a mere in- 



90 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

teraction. Similarly with wages ; the employer counts his 
pay roll as cost of production, but the laborer counts it as 
earnings ; whereas, to society as a whole, wages are neither 
the one nor the other. 

In the last analysis, payments of wages, interest, rent, or 
any other payments from one member of society to another 
must not be thought of as costs to society as a whole. This 
fact should now be clear ; yet it is commonly overlooked. 
When people talk of the cost of producing coal or wheat, they 
usually think of money payments. The items called costs 
of production are mostly payments from person to person, 
or interactions, at various stages of production. We have 
seen that each such item is two-faced and, in the final total, 
wipes itself off the slate. The only ultimate item of cost 
is labor cost ; that is, all the experiences of an undesirable 
nature which are undergone in order that experiences of 
an agreeable nature may be secured. We may conclude, 
therefore, that in the last analysis income consists of satis- 
factions and outgo of efforts to secure satisfactions. Between 
efforts and satisfactions may intervene innumerable inter- 
actions, but they all must cancel out in the end. They 
are merely the machinery connecting the efforts and satis- 
factions. At bottom, economics treats simply of efforts 
and satisfactions. This is evident in the case of an isolated 
individual like Robinson Crusoe, who handles no money; 
but it is equally true of the most highly organized society, 
though obscured by the fact that each member of such a 
society talks and thinks in terms of money. 

In the light of the foregoing principles we are now in a 
position to take a bird's-eye view of the income of any coun- 
try. Unfortunately, there are no available statistics for 
income in the United States. We can only guess as to what 
the amount of it may be. Possibly $20,000,000,000 worth 
of final objective income is annually enjoyed in the United 
States, of which about one third is in the form of nourish- 
ment or food uses, about one sixth in the form of shelter, 



Sec. 9] ADDITION OF INCOME 9 1 

and about one eighth in the form of clothing. These and 
the other items of the direct uses of wealth constitute the 
real income of society. In other words, our real income is 
what is often called our " living." Money-income, as we 
have seen, is not real income, but is converted or spent for 
real income in the form of our bread and butter. The 
money which the workman is paid in wages is not his real 
wages, but only his nominal wages. The real wages are 
the workman's living for which that money is spent. 
Money payments, as we have seen, cancel themselves out 
when we take a view of the whole, for they are not only 
receipts, but also payments. They therefore disappear, 
just as in our view of capital the bonds and stocks dis- 
appear, being not only assets, but also liabilities. And in 
exactly the same way the operations of production and 
transportation cancel themselves out in the total produc- 
tion of the farms. The five or more billions of dollars' 
worth of farm products, for instance, which we are produc- 
ing are not a part of the income of the country to be added 
to our consumption of food, etc., any more than they are 
a part of the costs of the country. To the farmer they 
represent income, but to those who buy of the farmer they 
represent outgo, while to the country as a whole they rep- 
resent neither income nor outgo. By the method of couples 
they vanish, and in their stead we have the consumption of 
bread and the other finished products which originated with 
the farm ; and should we, as is sometimes erroneously 
done, try to add together the value of these finished products 
and the value of the farm products, we should be guilty of 
double counting, as would be the case in capital accounting 
if we should add the value of mortgages to the value of 
real estate. 

The method of couples thus provides us with a view of real 
income, making clear of what it consists and of what it does 
not consist. If, however, we wish to know the extent to 
which various agencies have produced this income, we must 



92 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

look at the matter from the standpoint of the method of 
balances. From this standpoint, perhaps three quarters of 
the total income enjoyed in the country are produced by 
human beings, the workers of society, the remainder being 
produced by capital. 



CHAPTER VI 

CAPITALIZING INCOME 

§ i. The Link between Capital and Income 

We have now learned what capital and income are, and 
how each is measured. We have seen that the term " capi- 
tal " is not to be confined to any particular part or kind of 
wealth, but that it applies to any or all wealth existing at a 
given instant of time, or to property rights in that wealth, 
or to the values of that wealth or of those property rights. 
We have seen that income is not restricted to money- 
income, but that it consists simply of the benefits of wealth. 
We have seen that, like capital, income may be measured 
either by the mere quantity of the various benefits or by the 
value of those benefits. We have seen that in the addition 
both of capital-value and of income-value there are two 
methods available for canceling positive and negative items, 
called respectively the " method of balances " and the 
" method of couples." By the method of balances the nega- 
tive items in any individual account are deducted from the 
positive items in the same account, and the difference or 
" balance " gives the net capital (or income, as the case 
may be) with which that account deals, whether this net 
capital (or income) pertains to a particular owner or to a 
particular instrument. The method of couples, on the other 
hand, cancels items in pairs and is founded on the fact that, 
as to capital, every liability relation has a credit as well as 
a debit side — namely, as related to creditor and debtor 

93 



94 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

respectively ; and that, as to income, every interaction is at 
once a benefit and a cost — a benefit with respect to that 
good (or person) by which the event originates; a cost 
with respect to that good (or person) for which it originates. 

We observed that it is the method of couples alone which, 
if fully carried out, reveals wherein capital and income 
ultimately consist. This method, applied to capital, gradu- 
ally obliterates all partial rights, such as stocks and bonds, 
and exposes to view the concrete capital-wealth of a com- 
munity. The same method applied to income obliterates 
the "interactions" such as money payments between persons, 
and exposes to view an uncanceled outer fringe of benefits 
and costs. It leaves simply the final benefits of the wealth 
poured, so to speak, into the human organism — the satis- 
factions and the efforts of human life. 

We have seen that capital and income are in many re- 
pects correlative; that all capital yields income and that 
all income flows from capital and human beings. 

In spite of this close association between them, capital 
and income have thus far been considered separately. The 
question now arises : How can we pass from capital to in- 
come or from income to capital ? The bridge or link between 
them is the rate of interest. The rate of interest is the ratio 
between income and capital, both the income and the capital 
being expressed in money value. Business men, therefore, 
sometimes call the rate of interest the " price of capital " 
or the "price of ready money." Suppose, for instance, 
that a merchant wants a capital worth $10,000 and is willing 
to pay a bank $400 per year for it perpetually; then the 
price the merchant pays for the capital (or the ratio between 
the annual payment to the bank and the capital received 
from it) is $400 -f- $10,000 = y^, or four per cent, and the 
rate of interest is therefore said to be four per cent. 

We may also define the rate of interest as the premium 
on goods in hand at one date in terms of goods of the same 
kind to be in hand one year later. Present and future goods 



Sec. i] CAPITALIZING INCOME 95 

seldom exchange at par. One hundred doDars is worth more 
to-day than $100 due one year hence. To-day's ready 
money will always buy the right to more than its full value 
of next year's money. If, then, $100 to-day will exchange 
for $104 to be received one year hence, the premium — or 
rate of interest — is four per cent. That is, the price of 
today's money is four per cent above par in terms of next 
year's money ; for $104 ■£■ $100 exceeds $100 -s- $100 by ^f , 
which is four per cent. 
/ We have, then, two definitions of the rate of interest, 
viz., " the price of capital in terms of income " and " the 
premium which present goods command over similar goods 
due one year hence." 

But the two definitions are quite consistent, and either 
may be converted into the other. The rates of interest in 
the two senses are, in fact, normally equal. For instance, 
if a man borrows $100 to-day and agrees to pay it back in 
one year with interest at four per cent, we may conceive of 
him as selling for $100 a perpetual income of $4 a year — 
and at the same time agreeing to buy it back for $100 at the 
end of one year. But these two stipulations — to sell and 
to buy back — amount simply to an exchange of $100 
to-day for $104 next year — i.e., an exchange of present for 
future money at four per cent. Thus the rate of interest in 
the price sense becomes equivalent to the same rate in the 
premium sense. Or beginning at the other end, conversely, 
if we suppose $100 to-day to be exchanged for $104 due 
one year hence, so that the rate of interest in the premium 
sense is four per cent, we may suppose that when the time 
comes to receive the $104, only $4 of it is really kept, the 
$100 being again exchanged for $104 due the year follow- 
ing. If this process is repeated indefinitely, the man will 
continue to receive simply $4 a year ; and thus the rate of 
interest in the premium sense becomes equivalent to the 
same rate in the price sense. 

By means of the rate of interest we can evidently translate, 



96 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

as it were, present money-value into its equivalent future 
money-value, or future money-value into its equivalent 
present money-value. To translate any present value into 
next year's value, when interest is four per cent, we multiply 
this year's value by the factor 1.04; to translate any next 
year's value into this year's value, we divide next year's 
value by the factor 1.04. Thus if the rate of interest is 
four per cent, $25 to-day is the equivalent of $25 X 1.04 due 
one year hence, i.e., $26. Or, vice versa, $26 due one year 
hence is worth in the present $26 -r- 1.04, or $25. Again, 
$1 due one year hence is worth in the present $1 -J- 1.04, 
or $0,962. In general we may obtain the present worth of 
any sum due one year hence by dividing that sum by one 
plus the rate of interest. This latter operation is what we 
learned in our school arithmetics as " discounting," or find- 
ing the "present worth " of a sum given in the future. 
The rate of interest is thus a link between values at any 
two points of time — a link by means of which we may 
compare values at any different dates. 

The rate of interest, however denned, may be regarded as 
a species of price ; but it is a very different species from any 
prices mentioned in previous chapters. We have seen that 
the price of wheat enables us to translate any given number 
of bushels of wheat into so many dollars' worth of wheat ; 
and the prices of other goods in like manner, to translate 
their respective quantities into their money equivalents. 
Any price thus serves as a bridge or link between the quan- 
tity of any good and its value in some other good, as money. 
By means of prices we can convert a miscellaneous assort- 
ment of goods at any time into their money-value for that 
same time, or convert a miscellaneous assortment of benefits 
occurring through a period of time into their money- value 
for that same period. By such prices we may only convert 
quantities into simultaneous money-values. We cannot, by 
them, pass from one time to another. By means, however, 
of that unique price called the rate of interest, we may 



Sec. i] CAPITALIZING INCOME 97 

convert the money-values found for one time into their 
equivalent at another time. The rate of interest is thus the 
hitherto missing link necessary to make our reckoning of 
money equivalents universal. 

We are not yet ready to explain how the rate of interest 
comes about. In fact, we are not yet ready to explain how 
any prices come about. We must, for the present, take 
the rate of interest ready-made, as it were, just as we have 
taken other prices ready-made. In the preceding chapters 
we have seen how to form capital accounts and income ac- 
counts by assuming the prices necessary in each case to turn 
quantities into money-values. We are now ready, by as- 
suming a rate of interest, to show the relations between these 
two sets of accounts — i.e., to turn income into capital. It 
is worth while, however, at the outset to rid our minds of the 
idea that money is the one and only source of interest, just 
as we have already rid our minds of the idea that money is 
the only kind of wealth. We may, as we have seen, express 
a great many things in terms of money-value which are not 
themselves money. This habit leads us unconsciously into 
the fallacy of thinking of these things as though they were 
actual money. If we question a man who says, " I have 
$10,000 of money invested, and from it I get $500 of money 
each year as interest," implying a rate of interest of five per 
cent, he will be forced to admit that he has not really got 
$10,000 of money at all, and, perhaps, even that the $500 of 
money interest which he says he gets each year is not at 
first in money form. The true form of statement is simply 
that he has a farm (or other capital-wealth) which yields 
crops (or other products), and that both of these may be 
measured in terms of money, the farm being worth $10,000 
and the crops $500. Money need not enter at all except as 
a matter of evaluating in bookkeeping. Hence, if we are 
careful, we shall avoid thinking and speaking of a fund of 
$10,000 producing an interest of $500, but will instead think 
and speak of actual capital, such as farms, factories, rail- 



98 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

ways, or ships, worth $10,000 and producing actual benefits 
(such as yielding crops, manufacturing cloth, or transporting 
goods) which are worth $500. 

There is another confusion to be carefully avoided, viz., 
the confusion between interest and the rate of interest. If 
the interest from $10,000 worth of capital is $500 worth of 
benefits, the rate of interest is five per cent. Interest and 
the rate of interest are as distinct as value and price and in 
the same way. 

The rate of interest, then, is a sort of universal time price 
representing the terms on which men consider this year's 
values exchangeable in next year's or future years' values. 
By assuming this rate, we are enabled to convert future values 
into present, and present values into future. 

§ 2. Capital as Discounted Income 

But although the rate of interest may be used either for 
computing from present to future values, or from future to 
present values, the latter process is far the more important 
of the two. Accountants, of course, are constantly comput- 
ing in both directions, for they have both sets of problems to 
deal with ; but the problem of time valuation which nature 
sets us is that of translating the future into the present; 
that is, the problem of ascertaining the value of capital. 
The value of capital must be computed from the value of its 
expected future income. We cannot proceed in the opposite 
direction and derive the value of future income from the 
value of present capital. 

This statement may at first puzzle the student, for he may 
have thought of income as derived from capital, and, in a 
sense, this is true. Income is derived from capital-goods. 
But the value of the income is not derived from the value of 
those capital-goods. On the contrary, the value of the 
capital is derived from the value of the income. For not 
until we know how much income an item of capital will 



Sec. 3] CAPITALIZING INCOME 99 

bring us can we set any valuation on that capital at all. 
The wheat crop depends on the land which yields it. But 
the value of the crop does not depend on the value of the 
land. On the contrary, the value of the land depends on 
the value of its crop. 

The present worth of anything is what men are willing to 
give for it. In order that each man may decide what he is 
willing to give, he must have two bits of data : (1) some idea 
of the value of the future benefits his purchase will bring him, 
and (2) some idea of the rate of interest by which these future 
values may be translated into present values by discounting. 

With these data he may derive the value of any capital 
from the value of its income by means of the connecting 
link between them called the rate of interest. This deriva- 
tion of capital-value from income-value is called " capi- 
talizing" income. 

§ 3. The Discount Curve 

Let us assume that, for any given article of wealth or 
property, the expected income is foreknown with certainty, 
and that the rate of interest is also known. With these pro- 
visos, it is very easy, by the use of the rate of interest, to 
compute the capital-value of said wealth or property ; and 
this, whether the income accrues continuously or discon- 
tinuously ; whether it is uniform or fluctuating ; whether 
the installments of it are few or infinite in number. 

We begin by considering the simplest case ; namely, that 
in which the future income consists of a single item accruing 
at a definite instant of time. If, for instance, one holds a 
property right by virtue of which he will receive at the end 
of one year a benefit worth $1.04, the present value of this 
right, if the rate of interest is four per cent, will be $1. Or if, 
by virtue of the property, he is to receive a benefit worth $1 
one year hence, its present value (interest being at four per 
cent) is found, as we have seen, by dividing the Si by the 



IOO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

factor 1.04. The result is $1 -fr- 1.04, or $0,962. If the value 
to which the right entitles the owner is any other amount 
than $1, its present value is simply that other amount divided 
by 1.04. Thus the present value of $432 due in one year is 
$432 -7- 1.04, which is $41 5 -3 8 - 

And just as $1 to-day is the present value of $1.04 a year 
hence, so $1.04 a year hence will then be the present value 
of $1,082 a year later — i.e., two years from to-day. This 
is by compound interest. The $1.04 due at the end of the 
first year, when multiplied by the factor 1.04, gives $1,082 
as its equivalent at the end of the second year. The $1,082 
is therefore the equivalent of, and is called the amount of, 
to-day's $1 at the end of two years, just as $1.04 is the 
" amount " of to-day's $1 at the end of one year. Thus $1 
in hand to-day is the present value of $1,082 due two years 
hence, and, since the same ratio applies to all other sums, 
we may by simple proportion find the present value of any 
sum due two years hence. Thus let $1000 be the value two 
years hence of a present unknown sum. Then we have 
the following proportion : as this desired present sum is to 
its future amount $1000, so is a present $1 to its future 
amount, $1,082. Solving the proportion, we find $924.21 to 
be the required present sum, the value of which two years 
hence, interest being at four per cent, is $1000. 

We may illustrate this process by a diagram, much in the 
same way as geography is illustrated by a map. Curves 
sometimes puzzle beginners, but they are very important 
in economics, and make the subjects which they illustrate 
so clear and simple that the student should not fail to make 
himself master of their use at the outset. 

In Figure 2 the sum of $100 (represented as bB) is sup- 
posed to be due at the beginning of the year 1901. The 
problem is to find its value at the point of time represented 
by a ; that is, at the beginning of the year 1900, which we 
shall consider the "present instant" or simply the "pres- 
ent." This discounted value is a A. If we draw the line 



Sec. 3] 



CAPITALIZING INCOME 



IOI 



3.8533- 
96.1 5-90 * 



80 
70 
60 
50 
40 
30 

ao 
10 
a 
I900 I90I 

Fig. 2. 



400 



BA, its slope downward from right to left pictures the fact 
that a future sum becomes smaller and smaller in present 
value the further off in time it 
appears. This line BA is called 
the discount curve. It is not a 
straight line, but a line such that 
the height of any point on it rep- 
resents the discounted value of 
bB for the particular instant cor- 
responding to that point. If the 
$100 due in 1901 be discounted 
in 1900 at four per cent, its value 
in the latter date will be $96.15, 
the difference in value between 
the two points of time being 
$3.85, as indicated in the dia- 
gram, where aC is equal to bB, and AC is the difference 
between aC or bB, the amount due in 1901, and a A, the 
discounted value of that amount in 1900. 

We shall understand the nature of this curve better if, 
instead of taking merely the interval of one year, we con- 
sider a longer interval such as ten years. This is represented 
in Figure 3. In this figure, as in the preceding figure, the 
vertical distances (or "latitudes") above the base line 
represent sums of money and the horizontal distances (or 
" longitudes ") represent periods of time. The curve, 
A BCDM is the discount curve ; for the latitudes of these 
points, or their vertical distances above the base line, abcdm 
represent the values of the same capital-good at different 
instants of time ; and the longitudes or horizontal distances 
between them represent the intervals of time between those 
instants. Thus, let the point a represent the present 
instant, say the beginning of the year 1900, and let the 
longitude interval, ab, represent a year, say from the be- 
ginning of 1900 to the beginning of 1901. Using equal 
intervals for successive years, we have a A representing any 



102 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 



capital-value at the beginning of the year 1900, say $1, bB 
representing its equivalent next year, say $1.04, cC, the 
equivalent two years hence, and so on. We see that bB is 
what we have called the " amount," say $1.04, of a A put 
out at interest for one year, and cC is the "amount " of the 



¥ 


■ 






































M 






















































































■■ 


-8 










D; 
































g. 
































b- 


































E 


















































































































































































































































































































































a 




b 




c 




d 




























m 



KSo fl I I J [ [ ■ I I I I I 1 ' I I I [ I IJ^l''' '.50 

1.40 

1.30 

1.20 

1.10 

1.00 

.90 

.60 

.70 
,60 

.50 

40 

30 

.20 



1 9Q0 Ol * '02 03 '04 "05 '06 *07 '08 '09 'lO 

Fig. 3. 

same compounded for two years. Conversely aA represents 
the present value in 1900, or discounted value, of any one 
latitude on the curve, say bB, as well as of any other, such 
as cC or dD. The latitude of any point on the curve may 
thus be regarded as the " amount " of the sum represented 
by any preceding latitude or as the "present value" of the 
sum represented by any succeeding latitude. Thus, if the 
total breadth of the diagram am represents ten years, we 
may either say that mM is the amount, at the end of the 
ten years, of the present sum aA, or that a A is the "present 
value " of the future sum, mM, discounted for ten years. 
The line AM not only ascends, but at an accelerating rate 
— i.e., it does not ascend in a straight line, but gradually 
bends upward, forming a curve which we have called the 



Sec. 4] CAPITALIZING INCOME IO3 

" discount curve." The slope of the curve is due to the 
rate of interest, and the higher the rate of interest, the 
more steeply will the curve slope. This curve, if prolonged 
to the left to show what the " present value " was prior to 
the time a, will, of course, never reach the bottom line. It 
keeps becoming flatter and flatter, so that its distance 
above the line can never become zero. If there were no 
rate of interest or if the rate of interest were zero, the curve 
would not slope, but would be a horizontal line. 

§ 4. Application to Valuing Instruments and Property 

The principles which have been explained for obtaining 
the present value of a single future sum apply to many com- 
mercial transactions, such as to the valuation of bank assets, 
which exist largely in the form of " discount paper," or short- 
time loans of other kinds. The value of such a note is al- 
ways the discounted value of the future payment to which it 
entitles the holder. Similarly, the value of any article of 
wealth, reckoned when that wealth is in course of construc- 
tion, is the present value of what it will bring when com- 
pleted (less the present value of the cost of completion). 
For instance, the maker of an automobile will, at any of its 
stages in the course of construction, appraise it as worth the 
discounted value of its probable price when finished and 
sold, less the discounted value of the costs of construction and 
selling which still remain. Thus, if an automobile is to be 
sold for $5000 and requires a year before this sum will be 
realized, while it will cost to complete a sale $2000, which, 
for simplicity, we shall also assume is payable at the end of 
the year, the present value of the automobile will be the 
present value of S5000 minus $2000, which, at four per 
cent, will be ($5000 — $2000) -5- 1.04, or $2884.62. The 
element of risk should not, of course, be overlooked ; but 
its consideration does not belong here. 

Another application of these principles of capitalization 



104 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

is to goods in transit. A cargo leaving Sydney for Liverpool 
is worth the discounted value of what it will bring in Liver- 
pool, less the discounted value of the cost of carrying it 
there. Another good example is a young forest, which is 
worth the discounted value of the lumber it will ultimately 
form. 

Ordinarily, however, we have to deal, not with one future 
sum, but with a series of future sums. A man who buys a 
bond or a share of stock is really buying the right to a series 
of future items of income. But we can treat a series of items 
of income by discount curves in exactly the same way that 
we can treat one such item. 

For instance, let us consider a bond for $100 which runs 
for ten years and bears interest at five per cent. The prob- 
lem is to discover the present value of the bond. This is 
evidently the discounted value of the sums which the owner 
will receive from the bond ; in other words, the discounted 
value of the " principal," due ten years hence, together with 
the discounted values of the ten separate interest payments 
due respectively one year, two years, three years, etc., up 
to and including ten years from date. What this present 
value will be will depend upon the rate of interest by which 
these various sums are discounted. If the rate of interest 
used in discounting is the same as the rate of interest for which 
the bond is written, the present value of the bond will be par, 
or $100. This can be shown in various ways, as by calculat- 
ing separately all the eleven different sums to which the 
bond entitles the owner ; namely, the ten interest payments 
of $5 each and the final principal of $100. This calculation 
shows that the present value of the first interest payment of 
$5 (namely, that due one year hence) is $5 4- 1.05, or $4.76 ; 
of the second $4.76-=- 1.05, or, in other words, $5 4- (1.05) 2 ; 
of the third $54- (1.05) 3 ; and so on up to the tenth, the 
present value of which would be $5 4- (1.05) 10 . To this 
series must be added the present value of the principal, 
which, being discounted for ten years, is $100 4- (1.05) 10 , or 



Sec. 4] CAPITALIZING INCOME 105 

$61.39. The sum of all these will be $4.76 + $4.55 -f $4.32 
+ $4.11 + $3-92 + $3-73 + $3-55 + $3-38 + $3-22 + $3.07 + 
$61.39 = $100, which is the present value of the bond. 

Another method of getting the same result is, beginning 
our calculation at the time when the bond falls due in the 
future, to proceed backwards, discounting year by year. It 
is evident that the instant preceding the payment of the bond 
it will be worth $105 ; for at that time there is immediately 
due $5 of interest and $100 of principal. Any time within 
the year preceding, the value of the bond will evidently be 
the discounted values of this $100 and of this $5, the discount 
being for whatever portion of the year may be involved. 
Just after the ninth interest payment, and just one year be- 
fore the due date, when $105 are due, the value of the bond 
will evidently be found by discounting $105 for one year at 
five per cent. This gives $105 4- 1.05, or $100. In other 
words, the value of the bond at the end of nine years, just 
after the ninth interest payment, will be par, or $100. The 
instant preceding, namely, just before the ninth interest 
payment, the value of the bond will be more by the amount 
of interest payment, $5. That is, the value of the bond will 
be $105 just before the ninth interest payment and $100 just 
after. This sudden drop of $5 is due to the abstraction of the 
$5 of interest. For this reason, care is always taken at or 
near the time of interest payments to specify whether the 
bond is to be sold with the interest payment or without it, 
the higher price being paid if the bond is bought before the 
interest has been abstracted. 

Thus, the instant before the ninth payment of interest 
the bond is worth $105, just as was the case the instant before 
the tenth and last payment. By the same reasoning, there- 
fore, its value one year earlier, just after the eighth interest 
payment, will be $100 and just before, $105. In this manner 
we may proceed year by year back to the present, finding 
that the value of the bond will be $100 just after any interest 
payment and S105 just before. Its value will therefore be 



io6 



ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. VI 



$100 just after the first interest payment, which occurs one 
year hence, and $105 just before that payment. The value 
of this $105 at the present instant will therefore be $100. 

Reviewing these figures in the reverse order, we see that 
the value of the bond begins at $100, ascends to $105 one 
year from date, then drops suddenly to $100, ascends during 
the next year to $105, and then drops, and so on, ascending 
and dropping, as it were, by a series of teeth until the whole 
ten years have elapsed, when the value reaches its last 
height of $105 and then disappears altogether. In these 



100 




































( 


,. 




c 






b s" 




5^ 




5" 




5- 




5^ 




5,^ 




5J 




5- 




5^. 




5 


N 




































3" 




B 


90 






















































































60 






















































































70 






















































































60 






















































































SO 






















































































40 






















































































30 






















































































20 






















































































10 














































































d 




a 










5 




5 




5 




5 




5 




5 




5 




5 




5 




5 



M 



4-5 6 

Fig. 4. 



8 A 



oscillations, the gradual rise of $5 each year is evidently the 
interest accrued, while the sudden fall of $5 at the end of each 
year is the income taken out. 

The life history of such a bond can best be seen by the aid 
of Figure 4. The ten small, dark lines marked " 5 " stand- 



Sec. 4] CAPITALIZING INCOME 107 

ing on the base line MA (or the equivalents of these above 
the par line) and the long, dark line AB represent the eleven 
sums to which the bondholder is entitled ; the small, dark 
lines representing the interest payments in the ten suc- 
cessive years, and AB, the principal, $100, due at the end 
of the ten years. The problem is : Given these eleven sums 
to which the bondholder is entitled, to show in the diagram 
the value of the bond at different dates. Assuming as before 
that the rate of interest used in computing is 5 per cent, we 
obtain the results seen in Figure 4. We observe that the 
value of the bond, just before it becomes due, is the sum of 
A a (or BC), $5 of interest, and AB, the $100 of principal. 
This sum is represented by the vertical line AC, A a being 
equal to BC. One year earlier, just after the ninth interest 
payment A V (or B'C'), the value of the bond is A'B', 
or $100, being the discounted value of AC obtained by draw- 
ing the discount curve CB' ' . The value just before the ninth 
interest payment will be A'C ', or $105. Continuing in this 
manner backward, we obtain the series of " teeth " as in- 
dicated in the diagram. 

If the various discount curves in Figure 4 are all continued 
to the left (as in Fig. 5), they will divide the line MN, rep- 
resenting the present value ($100) of the bond, into the 
eleven parts of which it is composed, each part representing 
the present value of a future sum. Thus the present value 
of the principal is seen to be $61.39, this being the height 
above M at which the lowest discount curve meets MN; 
the present value of the last or tenth interest payment is 
$3.07, this being the difference in height between the two 
lowest discount curves ; the present value of the ninth 
interest payment is $3.22, as indicated in the next space 
above. Similarly, the present value of each of the other 
future payments is indicated in the diagram. 

As we pass from left to right in the diagram, we see that 
the value of the bond at the beginning of each year is 
$100, made up of the discounted values of all the remain- 



io8 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 



ing future receipts ; and that the value increases each year 
along a discount curve to $105 at the end of the year, im- 
mediately before the annual payment is made. The value 
then drops again to $100, when this annual income is 
received. It thus continues to oscillate (just as in Figure 
4) between $100 and $105 each year to the end, when the 
final income of $105 is received. 



100 




































c 




>• 






5^ 




5^ 




5^. 




S" - 




S, 




5, 




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5, 




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.,- 


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s' 


- 


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5;. 


»' 


8 


90 


& 


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_^- 


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.,• 


■' 


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^-^ 


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^» 


" 











.-- 


'^ 


^" 


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-* 


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fee 


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710 


i&. 


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-"' 


_^- 


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,.- 


■»■■" 




























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60 


'al. 


















































































5t 






















































































<o 






















































































30 


_( 


;i.3s 


















































































80 






















































































10 














































































d 




a 










5 




5 




S 




5 




5 




5 




» 




5 




5 




5 



M 



4 5 

Fig. 5. 



A A 



But often the bond is not sold at par because the rate of 
interest used by the purchaser in calculating what he is 
willing to pay for it may be more or less than the five per 
cent named in the bond. If the bond is sold above par, 
say at $108, this fact shows that the rate of interest real- 
ized by the investor is less than five per cent. In this 
case the bond is only nominally a " five per cent bond." 



Sec. 4] 



CAPITALIZING INCOME 



IO9 



The true rate of interest is that market rate which is actu- 
ally used for discounting the ten annual items of $5 each 
and the final item of $100, and gives the value at which the 
bond was actually bought, above or below par, as the case 
may be. If this true rate of interest be four per cent, the 
value of the bond will be $108, as found by the discount 
curves in Figure 6. 



* 


rs 




5^ 




s^ 




s. 




5. 


■j* 


5, 






















108.17*- 




5^ 




5, 




^ 


** 


C 




c 


Par 1 
Value}" 00 






























b 




5 




































EJ 






B 


90 
























































































80 






















































































70 






















































































60 






















































































50 






















































































40 






















































































30 






















































































20 






















































































IO 














































































a' 




a 










5 




5 




5 




5 




5 




5 




5 




5 




5 




5 



M 



3 4-5 

Fig. 6. 



A' 



Here the five per cent bond is said to be sold on a four 
per cent basis. The capital-value ($108.17), at the begin- 
ning of the period represented, of a so-called five per cent 
bond, sold or valued on a four per cent basis, is obtained 
just as before, except that we now reckon by discounting 
at four per cent instead of at five per cent. Thus, in Fig- 



IIO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

ure 6, we see that the value of the bond, just before it be- 
comes due, is $105, or AC; that its value one year earlier, 
just after the ninth interest payment, is A' B' ', or $105 -f- 
1.04, or $100.96, and, just before the interest payment, is 
A'C ', or $100.96 + $5, or $105.96 ; and so on back to its 
value at the beginning, MN, which is thus found to be 
$108. 1 7. 1 This is greater by $8.17 than the value of the 
bond as reckoned on the five per cent basis. The fact 
that four per cent has been used in our calculations instead 
of five per cent has made all of the discount curves less 
steep. 

We see, therefore, that nominally the rate of interest of 
the bond is not necessarily the actual rate of interest used in 
buying or selling that bond, and if the value of the bond is 
calculated on the basis of a rate of interest below the nominal 
rate of interest in the bond, the resulting value of the bond 
will be above par. Tracing the history of the capital-value 
of the bond reckoned at four per cent from the present 
toward the future, we may say that the rise in value dur- 
ing each year is the interest accruing during the year on the 
capital-value at the beginning of the year. Thus, the rise 
in value during the first year is four per cent of $108, or 
$4.32, and in the last year is four per cent of $100.96, or 
$4,038. It is also clear that the fall in the capital- value at 
the end of each year (except the last), when the payment 
of the nominal interest is made, is exactly $5. That is, the 
income taken out each year is greater than the interest 
accruing during the year ; hence the general decline in the 
capital-value of the bond. In the last year the income 
taken out is $105 ; although if the investor is wise, he will 
put back at least $100 into some other bond or equivalent 
property. 

1 Of course, the same result could be obtained by discounting separately 
at four per cent each of the eleven items to which the bondholder is en- 
titled and adding the results together. The elements of which MN is 
composed may then be easily indicated just as in Figure 5. 



Sec. 4] 



CAPITALIZING INCOME 



III 



The reverse is true if the present value of the bond is 
calculated on a six per cent basis, or on any other higher 
than the rive per cent named in the bond. Figure 7 repre- 
sents the case of a five per cent bond valued on a six per 
cent basis. In this case the discount curves are steeper 
than in Figure 4, and the value of the bond at present, ten 
years before it becomes due, is $92.61. In Figure 7, as in 
the preceding diagrams, we know that the rise of capital- 









































C'- 

5> 




5 


*> 


































r i. 




"N 


,<' 


£L 




5. 




~s 


S 


:. 




5 „ 




j^ 












e 




a 


*926l — 
so 












































































80 






















































































70 






















































































60 






















































































50 






















































































40 
























































































30 
























































































20 






















































































10 












































































5 






a 










5 




5 




5 




5 




5 




5 




5 




5 




5 


I 


M 








> 




3 


1 


3- 




5 


i 






7 


t 


J 


/ 


\* 


4 


\ 



Fig. 7. 



value during any year is always the accruing interest on 
the capital-value at the beginning of that year. Thus, the 
rise in the first year will be six per cent of $92.61, that is, 
$5.55, and the rise during the last year will be six per cent 
of S99.05, namely, $5.95. It is also clear that the drop in 
capital-value at the end of each year is, as before, equal to 



112 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

the income taken out, or $5 ; that is, the income taken out 
each year is less than the interest accruing during the 
year ; hence the general increase in the capital- value of the 
bond. 

It will be seen (as shown in the three figures, 4, 6, and 7) 
that the final value of the bond just before it becomes due 
will be $105 in all three cases, but that the present value is 
different in each case; namely, $100, $108.17, and $92.61. 
In each case the value zigzags year by year, but approaches 
in a general way $105 as its final value. If the five per 
cent bond is sold on a five per cent basis, the value of the 
bond is maintained year by year, as seen in Figure 4, 
where the curve indicating capital-value runs in general 
horizontally ; if the bond is sold on a four per cent basis, its 
value in general decreases, as shown by the descending 
trend of the curve in Figure 6 ; while, if the bond is sold on 
a six per cent basis, it tends to increase in value, as shown 
by the general upward trend in Figure 7. 

Elaborate tables have been constructed, called " bond- 
value books," calculated on the foregoing principles. They 
are used by brokers for indicating the true value of bonds on 
different bases. They are also used for solving the converse 
problem, viz., for finding the true rate of interest "realized" 
when a bond is bought at a given price. The following table 
is an abridgment of these brokers' tables, for a five per cent 
bond. The prices of such a bond are in all cases the prices 
immediately after an installment of interest has been re- 
ceived. In all cases the gradual increase in capital-value 
during any time is equal to the interest accruing during that 
time, while the sudden decrease at any time is equal to the 
value of the income taken out at that time. The only 
exceptions to these statements are when capital- value varies 
up or down because of changed opinion as to the chances of 
future income ; but we are here assuming that there are no 
uncertainties to be reckoned with. 



Sec 4] 



CAPITALIZING INCOME 



"3 



RATES OF INTEREST 
Five Per Cent Bond 







Years to Maturity 




Price 










1 


S 


10 


I02 


3-° 


4.6 


4.8 


IOI 


4.0. 


4.8 


4.9 


IOO 


5-o 


5-0 


5-o 


99 


6.1 


5-2 


5-i 


98 


7-i 


5-5 


5-3 



From this table we see that if the bond is sold at $102, 
and has one year to run, it will yield the investor three per 
cent ; that is, if three per cent is used in calculating its 
value, this value will be $102. Again, if the bond has five 
years to run and is sold at $102, it yields the investor 4.6 
per cent ; and if ten years, 4.8 per cent. If the bond is 
sold at $98 and has one year to run, it yields the investor 
7.1 per cent ; if ten years, 5.3 per cent. If it is sold at par, 
it yields five per cent, whatever may be the number of years 
it has to run. 

The same principles as have just been applied to valuing 
bonds apply also to valuing any other article of property or 
wealth. The student will find it a useful exercise to draw 
diagrams for other cases. He may construct a series of 
diagrams, the vertical lines representing the successive items 
of income expected, and beginning at the last item proceed 
backward year by year, by a series of teeth, to obtain the 
present value of the capital. The value of the capital must 
always be first traced backward, but, after it has been obtained, 
we may retrace our steps. It will be observed that the value 
of the capital always ascends gradually during each year, 
and descends suddenly whenever an item of income is de- 
tached. It will also be observed that the general trend of 



114 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

value of the bond will proceed upward if the items of income 
detached are less than the appreciation which occurs as we 
approach nearer to those future anticipated income items; 
downward, if the income items are greater than the apprecia- 
tion ; and neither upward nor downward, but horizontally, 
if the items of income detached are equal to the apprecia- 
tion, i.e., just enough each year to offset the ascent of the 
discount curve. 

§ 5. Effect of Changing the Rate of Interest 

From what has been said, it is evident that the value of 
any article of capital depends very greatly on the rate of 
interest. If there were no rate of interest, or if, in other 
words, the rate of interest were zero, the value of the capital 
would be simply the sum of the values of the anticipated 
benefits. In the case of the five per cent bond, for instance, 
running for ten years, if reckoned on a zero per cent basis, its 
value would be simply the sum of the $100 and the ten in- 
terest payments, amounting to $50, or a total of $150. The 
effect of changing the rate of interest will thus be to change 
the value of capital in the opposite way. If the rate of 
interest falls, as in general has been the case during several 
generations, the value of bonds and other capital tends to 
rise. This is one reason why the value of land and other 
real estate has increased in value. Of course, the change 
in value of capital will be due also to many other circum- 
stances than the change in the rate of interest, and, moreover, 
the change in the rate of interest will not be the same on all 
articles of capital. The capital, the income from which is 
most remotely future, will be most affected. The following 
table shows 1 the effect of lowering the rate of interest from 
5 per cent to 2\ per cent on five typical articles. 

1 The figures in this table are worked out by the principle of dis- 
counting previously explained. 



Sec. 5 ] 



CAPITALIZING INCOME 



US 



Capital 


Rate of 
Net Income peb Year 


Total .Capital-value 
Income (Int. at 5 %) 


Capital-value 
(Int. at 2 J %) 


Land 
House 

Horse 
Suit of 

clothes 
Loaf of 

bread 


$1000 per yr. forever 
$1000 per yr. for 50 

yrs 

Si 00 per yr. for 6 yrs. 
$20 1st yr.; $10 2d 

yr. ..... . 

$36.50 per yr., for 1 

day 


Infinite 

$50,000.00 
600.00 

30.00 

.10 


$20,000.00 

18,300.00 
508.00 

28.00 

.10 


$40,000.00 

28,400.00 
5SI-QO 

29.OO 
.IO 



If the value of the benefits derivable from these various 
articles continues in each case uniform, but the rate of in- 
terest is suddenly cut down from 5 per cent to 2\ per cent, 
there will result a general increase in the capital-values, but 
a very different increase for different articles. The more 
enduring ones will be affected the most. These effects are 
seen in the last two columns of the table. When the rate 
of interest is halved, the value of the land will be doubled, 
rising from $20,000 to $40,000, but the value of the house 
will rise by only about sixty per cent, namely, from $18,300 
to $28,400 ; the value of the horse will rise only ten per 
cent, namely, from $508 to $551 ; the value of the suit will 
rise only from $28 to $29; and, finally, the value of the 
loaf of bread will not rise at all, but will remain at 10 
cents. We see from the changes in the values of these five 
types of articles that the sensitiveness of capital-value to a 
change in the rate of interest is the greater, the more 
remote the income. 



CHAPTER VII 

VARIATIONS OF INCOME IN RELATION TO CAPITAL 

§ i. Interest Accrued and Income Taken Out 

We have seen how the value of capital is derived from that 
of income. We have also seen that the value of capital 
rises in anticipation of income and falls with its realization. 
The alternate rise and fall may or may not be equal. From 
the principles explained it is evident that the rise of the capi- 
tal-value as it ascends on the discount curve is equal to the 
interest accrued on that capital during that time, while the 
fall in that capital- value due to the taking out of income 
is equal to the income taken out. If the income taken out 
is just equal to the interest, the capital is thereby restored 
to its original value. If more than this amount of income 
be taken out, the capital-value will be impaired; if less, the 
capital-value will increase. 

When a man is said to own a capital fund of $1000, this 
means simply that he owns capital-goods worth that much ; 
and these capital goods are worth that much simply be- 
cause, in terms of money, the discounted value of the 
expected income from them is that much. The income 
which he expects may be a perpetual income flowing uni- 
formly; or an income like that from the bond, flowing 
uniformly for a limited time, at the end of which a large 
lump sum, ordinarily called the " principal," is returned in 
addition ; or any one of innumerable other forms. Thus if 
we assume that five per cent is the rate of interest used in 

116 



Sec. i] VARIATIONS OF INCOME 117 

calculating the capital- value, the $1000 may represent a per- 
petual annuity of $50 per year ; or an annuity of S50 a year 
for ten years, together with $1000 at the end of that period ; 
or $100 a year for fourteen years, after which nothing at 
all ; or $25 a year for ten years, followed by $167.50 a year 
for ten years, after which nothing at all ; or any one of in- 
numerable other forms. The student can easily prove that 
any one of these series of incomes, when discounted at five 
per cent, will make up a present value of $1000. 

In the first case the income taken out ($50 a year) is 
exactly equal to the annual accrued interest, for $50 is the 
interest for one year at five per cent on $1000. The same 
is true of the second instance mentioned, that of the five 
per cent bond, except that the last income item taken out 
($1050) exceeds the interest for the preceding year by 
$1000, thereby reducing the value of the bond to zero. 

In the third case the income taken out the first year 
is $100, while the interest accrued in that year is only $50. 
Thus the income taken out exceeds the accrued interest by 
$50. This excess of $50 involves a reduction of $50 in the 
capital- value of the property, which therefore becomes $950 
instead of $1000. Thus, at the end of the first year and 
after the $100 of income has been taken out, $950 is the 
discounted value of the remaining thirteen items of $100 a 
year for each year. In the second year the interest (on 
$950) is $47.50; whereas the income taken out is $100, the 
difference being $52.50. Hence, at the end of the second 
year, the capital-value of the remaining payments has been 
reduced by $52.50, becoming $897.50. Similarly, the capi- 
tal-value of the property decreases each year by the excess 
of the income over the accrued interest until the last in- 
come item of $100 is received ; after which, no more income 
being anticipated, the capital- value is zero. 

In the fourth case, the interest accruing during the first 
year is $50, whereas only $25 income is taken out at the 
end of the year, the difference being $25. Hence, at the 



Il8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

beginning of the second year the capital- value of the bond 
becomes $1025. During the second year, the interest (on 
$1025) is $51.25. After the receipt of the second income 
item of $25, therefore, the capital-value of the bond is in- 
creased by the difference ($26.25) and becomes $1051.25. 
Similarly, the value of the bond increases until after the 
payment of the tenth income item of $25, when it becomes 
$1314.43. The interest on this amount in the eleventh 
year is $65.72 ; whereas the income taken out that year, 
and each of the remaining nine years, is $167.50. Hence, 
from the beginning of the eleventh year to the end of the 
twentieth, the capital-value of the bond decreases, finally 
reaching zero at the end of the period. 

The principle here shown may be summarized as follows : 
(1) When a property yields a specified foreknown income, 
and is valued by discounting that income at a specified rate 
of interest, if the income taken out is equal to the interest 
accrued, the value of the capital will be restored each year 
to the level of the year before. (2) If the income taken out 
exceeds the interest accrued, the value of the capital will fall 
below that of the year before, the amount of the fall being 
equal to the amount of the excess. (3) If the amount of in- 
come taken out is less than the interest accrued, the value of 
the capital will rise above that of the year before, the amount 
of the rise being equal to the amount of the deficiency. 

Briefly, the general principle connecting income taken out 
and interest accrued is that they differ by the net apprecia- 
tion or depreciation of capital. It is thus possible to describe 
interest accrued as income taken out less depreciation of cap- 
ital, or as income taken out plus appreciation of capital, 

§ 2. Illustrations 

In order that these important relations may be as clear 
and vivid as possible, we shall illustrate them by concrete 
examples, and by business accounting. The following table 



Sec. 2] 



VARIATIONS OF INCOME 



119 



gives the income supposed to be taken out for five selected 
kinds of capital-wealth ; the capital- value found by dis- 
counting that income at five per cent ; the accrued interest 
for the first year ; the resulting change in net appreciation 
or depreciation of capital-value ; and the ratio of the first 
year's income to the original capital- value. 











Increase 


Ratio of 
First 
Year's 

Income to 

Original 
Capital- 


Capital- 


Income taken out 


Capital- 


Interest 
accrued 


( + ) or De- 
crease ( - ) 


wealth 


per Year 


(Int. at s %) 


for First 
Year 


of Capital- 
value in 
First Year 














Forest land 


$1000 a yr. for 
14 yrs. and 
then $3000 a 








% 




yr. forever . 


$40,000.00 


$2000.00 


+ $1000.00 


2-5 


Farm land 


$1000 per yr. 












forever . . 


20,000.00 


IOOO.OO 


O.OO 


5-o 


House 


$1000 per yr. 












for 50 yrs. 


18,300.00 


915.OO 


-85.OO 


5-4 


Horse 


$100 per yr. for 












6 yrs. . . . 


508.OO 


25.40 


-74.60 


19.6 


Suit of 


$20 1st yr. ; $10 










clothes 


2d yr. . . . 


28.OO 


I.40 


-18.60 


7i-4 



i. The forest land yields $1000 worth of income the first 
year on a capital-value of $40,000, from which, on the five 
per cent basis assumed, the interest accrued would be five 
per cent of $40,000, or $2000. Consequently, the income 
taken out ($1000) is less than the interest accrued ($2000) 
by Siooo. Therefore the forest will appreciate in the year 
by the excess, $2000 — $1000, or $1000, and will be worth 
$41,000 at the end of the year. Similarly, it will continue 
to appreciate for fourteen years, when it will be worth 
$60,000 ; after which the income that is annually taken out 
($3000) will be equal to the annual accrued interest on 
$60,000. 

2. The farm land yielding $1000 a year in perpetuity 
is, on the five per cent basis, worth $20,000, and continues to 



120 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

be worth that amount each succeeding year. The income 
taken out ($1000) is always equal to the interest accrued 
from $20,000. 

3. The house yields an income of $1000 on a capital- 
value the first year of only $18,300. The interest accrued on 
$18,300 would be five per cent of $18,300, or only $915. The 
consequence is an excess of income taken out over interest 
accrued of $1000 — $915, or $85, and a corresponding fall 
of $85 in the value of the capital. That is, the house depreci- 
ates by $85 in the year, or from $18,300 to $18,215. It will 
continue to depreciate each year until its value vanishes 
entirely at the end of fifty years. 

4. The horse also depreciates, and very fast. Its owner 
realizes from the horse an income of $100 on a capital- value of 
$508, from which the interest accrued would be only $25.40. 
The difference between the income taken out and the interest 
accrued is $100 — $25.40, or $74.60, and the horse will lose 
that much in value during the year, and will continue to 
depreciate in value for all of the six years during which it 
yields income. 

5. The suit of clothes yields an income the first year of 
$20 on a capital of $28, from which the interest accrued 
would be only $1.40. It therefore depreciates by the differ- 
ence, $20 — $1.40, or $18.60. 

In all cases the interest accrued is 5 per cent of the capital- 
value, while the income taken out is in some cases a higher, 
and in some cases a lower, percentage. Expressed in per- 
centages, the actual rate of value-return {i.e., ratio of income 
taken out to capital) on the forest land is 2.5 per cent; 
on the farm land, 5 per cent; on the house, 5.4 per cent; 
on the horse, 19.6 per cent; and on the suit of clothes, 71.4 
per cent. The more rapidly the income is taken out, the 
greater the rate of value-return realized ; but (if that rate ex- 
ceeds the rate of interest) the more rapidly will the capital 
be exhausted. The house yields a rate but slightly higher 
than the rate of interest, and lasts 50 years ; the horse yields 



Sec. 3] VARIATIONS OF INCOME 121 

a rate nearly 4 times the rate of interest, but it lasts only 6 
years ; and the clothes yield a rate over 14 times the rate of 
interest, but last only 2 years. The farm land, which yields 
a rate exactly equal to the rate of interest, lasts forever, 
while the forest land, which yields a rate only half the rate 
of interest, not only lasts forever, but also increases in 
value for the first 14 years. 

The various cases supposed may also be illustrated by the 
dividends declared by a joint stock company. If a company 
declares dividends of five per cent, when it earns five per 
cent, these dividends will be the interest accrued on the 
capital and will leave it intact. If the dividends are less than 
five per cent, capital will be accumulated; that is, a "sur- 
plus " will be added to the original capital. If the dividends 
are greater than five per cent, the capital or surplus pre- 
viously accumulated will be decreased. In the last-named 
case the company is said to pay its dividends partly "out of 
capital." Such a practice is unusual, and when it occurs is 
generally condemned because of an assumed intention to de- 
ceive as to the ability to pay dividends. 

A case at the opposite extreme occurs when the dividends 
are made unusually small in order that the capital may be 
increased. There is in New York City a company which has 
never declared any dividends, but has been rolling up a large 
surplus for years, and whose stock is for this reason much 
above par. 

§ 3. Confusions to be Avoided 

With all the preceding explanations and illustrations the 

distinction between income taken out and interest accrued 

/should be clear. (Interest accrued is the income which 

ought to be taken out in order to maintain capital intact, 

neither impaired nor increased.] 

Of the two concepts, incoine taken out and interest ac- 
crued, the former is by far the more fundamental. Every- 
thing else depends upon income taken out — the value of the 



122 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

capital, and therefore the value of the interest upon that capi- 
tal, which is the interest accrued, as we have seen. We 
cannot, as would at first seem possible, begin with capital- 
value and derive the actual income from it; nor can we 
begin with interest accrued, for interest accrued presupposes 
some capital-value. That is, interest accrued depends on 
capital- value, and capital-value depends on income to be taken 
out. The order of dependence, then, is income taken out, 
capital- value, interest accrued. It is not uncommon to con- 
fuse these three concepts. The illustrative table (§ 2) will 
help to keep us from confusing them. For instance, from 
this table we see clearly one reason why certain articles 
have been erroneously identified with income. Clothes have 
nearly the same capital-value as income-value, so that, if a 
person were not accustomed to fine distinctions, he might 
think it unnecessary to discriminate between the $30, which 
is the total value of the use of the clothes for two years, which 
is, therefore, income, and the $28, which is the value of the 
clothes themselves, and which is, therefore, capital. There is 
almost as much danger of such confusion in the case of the 
horse ; for there is no very great difference between the $600, 
the value of the use of the horse, and the $508, which is the 
value of the horse. As we pass to the more enduring articles, 
there emerges so wide a difference between the value of the 
use of an article and the value of the article itself, that there 
is no difficulty in distinguishing between them. But if the 
distinction is valid in one case, it is valid in the others. We find 
no difficulty in distinguishing between the shelter of a house, 
which is income, and the house itself, which is capital ; nor 
between their values. Thus the shelter is worth $1000 a 
year for 50 years (or $50,000 in all), whereas the house itself 
is the discounted value of all this $50,000, or only $18,300. 
We ought to find no greater difficulty in distinguishing be- 
tween the use of the horse and the horse, nor between the 
use of the clothes and the clothes. 
/The more rapidly any capital yields up its benefits, that is, 



Sec. 3] VARIATIONS OF INCOME 1 23 

the greater the rate at which its income is taken out, the more 
the danger of confusing the capital with the income it yields. 
We have shown the tendency to confuse three concepts — 
interest accrued, income taken out, and capital-value. We 
have also dealt with a fourth concept, which must not be 
confused with the other three, viz., appreciation or deprecia- 
tion. Appreciation is also sometimes called savings, for 
savings in its broadest sense includes more than simply saved 
money. It includes all the net increase in capital-value after 
all income has been detached. It is the net appreciation, 
or the difference between the total appreciation of capital 
(interest accrued) and the income taken out. Savings are 
therefore still a part of capital. They are the part of capi- 
tal saved from being taken out for income. They are not 
a part of income taken out. The individual is always 
struggling between saving more capital and taking out more 
income. He cannot do both — have his cake and eat it too. 
A savings bank depositor is sometimes thought to draw 
income from his deposit when the interest merely " accumu- 
lates " in the bank. This is an error. The bank renders 
income to the depositor when, and only when, money is 
drawn out of it. It occasions him outgo when, and only 
when, money is put into it. If the depositor merely lets his 
deposit accumulate, he derives no income and suffers no out- 
go. There is no effect on income. The only effect is upon 
capital, which is made to increase. If we accept the fiction 
that the man who allows his savings to accumulate virtually 
receives the interest, we must, to be consistent, also accept 
the fiction that he redeposits it and so cancels the receipt. 
If the teller hands over the interest across the counter, the 
depositor's account certainly yields up " income " to him, 
but if the depositor hands it back, the account occasions 
" outgo," and the net result is simply a cancellation. To 
allow a deposit to accumulate is evidently equivalent to this 
double operation. We see, then, that net appreciation is not 
income, but is an addition to capital. Likewise, net de- 



124 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

preciation is not outgo, but is a subtraction from capital. 
Almost every article except land ultimately depreciates in 
value, owing to the fact that the services which it still re- 
mains capable of rendering gradually diminish in number 
and value. The approaching cessation of services may be 
due to physical wear and tear, but not always. Sometimes 
the expression " wear and tear " is a misnomer. There are 
articles which suffer no physical change, but of which the 
services, nevertheless, last only a limited period. On the 
Atlantic coast the fishermen sometimes construct temporary 
platforms which are pretty sure to disappear in the Septem- 
ber gales. It is evident that without any physical deteriora- 
tion during the summer the value of such property must, 
nevertheless, decrease rapidly as the end of the fishing sea- 
son approaches. The " World's Fair " buildings at St. 
Louis depreciated, during the brief period of the fair, from 
$15,000,000, which was first paid for their construction, to 
$386,000, for which they were sold after they had served 
their main purpose during the few months of the Fair. The 
buildings equipping a mine become worthless when the mine 
is exhausted. " Wear and tear," therefore, is a phrase 
which we should use only in a metaphorical sense. Even 
when there is actual physical deterioration, this deterioration 
affects the value only in so far as it decreases or terminates 
the flow of income, and not directly because of a physical 
change in the capital which bears the income. 

There are, then, four concepts which we must keep dis- 
tinct. Stated in the order of dependence on income taken 
out, these concepts are : — 

(1) Income taken out. 

(2) Capital- value (the discounted value of expected in- 
come to be taken out) . 

(3) Interest accrued (the interest on capital-value). 

(4) Appreciation (the excess of interest accrued over 
income taken out), and its opposite, or depreciation (the 
excess of income taken out over interest accrued). 



Sec. 4] VARIATIONS OF INCOME 125 

§ 4. Standardizing Income 

Various devices have been used to make income taken out 
agree with interest accrued. The method of the depre- 
ciation fund has already been mentioned under income 
accounts, and before the relation of income to capital was 
explained. By means of a depreciation fund, an irregular 
income is converted into a regular income ; and we know 
that the capital-value of a perpetually regular income will 
remain constant. For instance, the possessor of $18,300 
purchases a house and obtains at first an income worth 
$1000 a year. He knows, however, that by the end of 
50 years the house will need to be rebuilt, and therefore 
sets aside a depreciation fund into which he pays annually 
a sum equal to the depreciation of his house. This, in the 
first year, is $85, as we have seen. The depreciation fund 
costs him this sum as outgo the first year. At the end of 
50 years his depreciation fund, accumulated at interest, 
is large enough to rebuild the house. Although the house 
by itself does not yield him a uniform income of $915 for- 
ever, but instead $1000 a year for 50 years, yet the house 
and the depreciation fund taken together yield him the $915 
in perpetuity, or as long as he keeps up the system. 

In this way, any article of capital may be made to yield a 
uniform perpetual income, not by itself, but conjointly with 
a depreciation fund. The latter is often forgotten. Only 
by actually paying into this fund can income taken out be 
made to agree with interest accrued. Merely to reckon what 
the depreciation is will not make the income taken out agree 
with the interest accrued. Reckoning depreciation is as 
poor a substitute for providing a fund to meet depreciation 
as Beau Brummel's keeping a dinner hour was a substitute 
for a dinner. Of course, depreciation payments only rectify 
or change the distribution in time of one man's income at the 
expense of some other man's income. That is, every addi- 
tion and subtraction caused in the one man's income implies 



126 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

equal and opposite changes in some other man's. A banker 
must be found who is willing to take the $85 and succeeding 
payments made into a depreciation fund and pay back 
$18,300 at the end of 50 years. 

To society as a whole such purely shifting devices are 
inapplicable, for society can find no outside party on whom 
to shift the fluctuations. There is, however, a method by 
which society's income may be made more or less uniform ; 
namely, by assorting and combining the various instruments 
of capital-wealth so that the various income streams may 
be mutually compensatory. In a new country just being 
opened up, such as the early American colonies, little in- 
come can at first be obtained because almost all the stock of 
wealth, especially the land, is, with respect to ability to 
yield income, in an embryonic stage, so to speak. The first 
settlers must therefore wait several years before they can 
get a comfortable living. An older country, on the other 
hand, such as the United States to-day, will have its capital 
better assorted. Only part of its capital will be in the em- 
bryonic stage — young forests, new mines, railways in pro- 
cess of construction ; other capital will be in full operation, 
yielding a large stream of benefits — older forests, mines, 
railways, factories, farms, dwellings, etc. 

The last-named method may sometimes be applied even 
to a case of private enterprise ; for instance, in the case of 
capital which consists of a large number of instruments at 
different stages of production or consumption. If a weaving 
mill is equipped with twenty looms of the same degree of 
wear, the value of this plant will evidently diminish, and a 
depreciation fund may be necessary. But if the twenty 
looms are evenly distributed throughout the different stages 
of wear, and if we assume that one loom wears out each 
year, no depreciation fund will be necessary. The replace- 
ment of one loom annually is equivalent to such a deprecia- 
tion fund, and the capital is thereby maintained at a uniform 
level. 



SEC. 5] VARIATIONS OF INCOME 1 27 

§ 5. The Risk Element 

There is one important feature in the relation between 
capital-value and income-value which has not yet been 
mentioned. This is the fact that at any point of time when 
we take account of capital-value, the future income from 
which it is obtained is only imperfectly foreknown. The 
capital-value is the discounted value of the future expected 
income, with all the chances of loss or gain included in pres- 
enTexpectations. 

Hitherto we have assumed that the entire future history 
of the capital in question is definitely known in advance ; 
in other words, we have ignored chance. The articles of 
capital which were taken for illustration were supposed to 
yield definite future income which could be counted upon, pre- 
cisely as interest on a bond may be counted on by the bond- 
holder. But as every enterprise offers chances of both gain 
and loss, we cannot close our discussion of the relation of 
income to capital without some account of how these chances 
affect the matter. 

It has been explained that capital-value increases with 
the approach of an anticipated installment of income, and 
diminishes when that installment is taken out or received. 
These changes in capital-value take place when the future in- 
come is regarded as certain. The introduction of the ele- 
ment of chance will bring other and even more important 
changes in capital- value. If we take the history of the prices 
of stocks and bonds, we shall find it to consist chiefly of a 
record of changing estimates due to what is called chance, 
rather than of a record of the foreknown approach and de- 
tachment of income. Few, if any, future events are entirely 
free from uncertainty. In fact, property, by its very defini- 
tion, is simply the right to the chance of future benefits. 
The owner of a mine takes his chances as to what the mine 
will yield ; the owner of an orange plantation in Florida takes 
his risk of winter frosts ; the owner of a farm assumes risks 



1 28 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

as to the effect of sun and rain and other meteorological 
conditions, as well as the risks of the ravages of fire, insects, 
and pests generally. In buying an overcoat a man takes some 
risk as to its effectiveness in excluding cold, and as to the 
length of time it will continue to be serviceable. Even what 
are called " gilt-edged " securities are not entirely free from 
risk. Strictly speaking, therefore, every owner of property 
is a risk taker. 

We may now take a bird's-eye view of the capital and 
income of any country, such as the United States. We 
have seen that the capital of the United States consists of 
over a hundred billion dollars' worth of articles of various 
kinds, mostly real estate, and that the income consists of 
several billion dollars' worth of nourishment, clothing, shel- 
ter, and other satisfactions. We now see how the capital 
is related to the income. The larger part of the income is 
produced by human work, and is therefore not yielded by 
capital (unless we enlarge our definition of wealth so as to 
include free human beings). But the remainder comes 
from capital and gives value to that capital, just as fruit 
comes from a tree and gives value to the tree ; that is, the 
one hundred and odd billions of dollars which our national 
capital is worth represent merely the discounted value of 
the nation's net future satisfaction which, it is expected, 
that capital will ultimately produce. The value of our 
capital is merely the present value of the future " living" 
of ourselves and our descendants. Most of the capital does 
not directly produce that " living " — does not turn out 
bread and butter ready-made ; but contributes to it only in- 
directly — by growing the wheat which will be made into 
bread or pasturing the cows from whose milk the butter will 
be churned. But all of the capital has as the goal toward 
which its services aim the production of bread and butter 
and the other necessities, comforts, and amusements of life 
which constitute our " living " or real income ; and each 
individual article of this capital derives its value from the 



SEC. 6] VARIATIONS OF INCOME 1 29 

value of the services it is expected to render in helping to- 
ward this goal. These expectations may never be realized, 
and often are not realized, or the expectations may be sur- 
passed by realization. But in either case it is expectation 
and not realization which gives the value to capital; and 
any change in expectations, as occasioned by a shock to 
business confidence, a rumor of war, or any other cause, will 
tend to change the value of our national capital. 

§ 6. Review 

The preceding chapters are intended to give a definite 
picture of the mass of capital and its benefits to man. In 
such a picture we see man standing in the midst of a 
physical universe ; the events of this universe affect his life 
favorably or unfavorably. Over many of these events he 
can exercise no control or selection; they constitute his 
natural environment. Over others he exercises selection 
and control by assuming dominion over part of the physical 
universe and fashioning it to suit his own needs. The parts 
of the material world which he thus appropriates consti- 
tute wealth, whether they remain in their natural state or 
are " worked up " by him into products to render them more 
suitable to his needs. This mass of instruments will con- 
sist of the appropriated parts of the surface of the earth, the 
buildings and structures attached to the soil, and the mov- 
able objects or " commodities " which man possesses and 
stores up. 

This mass of instruments serves man's purpose in so far 
as its possession enables him to modify the stream of occur- 
rences. By means of land and the modifications to which 
he subjects it he is enabled to increase and improve the 
growth of the vegetable and animal kingdoms in such a way 
as to supply him with food and the materials for constructing 
other instruments. By means of dwellings and other build- 
ings he is enabled to avert or minimize the unfavorable 



130 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

effects of the elements upon his body and upon the articles 
of wealth which he stores in those buildings. By means of 
machinery, tools, and other instruments of production, he 
is enabled to fashion new instruments, to add to his store of 
goods or to supply the place of those destroyed or worn out. 
By means of the final finished products which minister to his 
more immediate enjoyments — such, for instance, as food, 
clothing, books, ornaments — he is enabled to consummate 
the purposes for which the entire mass of wealth is produced 
and kept in existence ; namely, the satisfaction of his desires, 
whether these be for the necessities, the comforts, the lux- 
uries, or the amusements of life. In jthese and other ways 
the stock of wealth will modify the course of natural events 
in a manner more or less agreeable to the owner. These 
desirable changes in the stream of events which occur by 
means of wealth constitute the benefits of wealth. But these 
benefits are obtained by dint of certain costs. In the last 
analysis, costs are simply human efforts, and benefits are 
simply human satisfactions; but the interval between ef- 
forts and satisfactions is divided into so many stages, and 
at each of these stages there are so many processes of pro- 
duction or exchange, that these intermediate occurrences, 
or interactions, are much more in evidence than either the 
efforts which precede them or the satisfactions which follow. 
Each interaction is accounted as a benefit with respect to 
the producing article or agent, and a cost with respect to 
that on account of which it occurs. 

The whole economic structure therefore — all that is 
represented in capital and income accounts — rests on two 
ultimate elements, namely, efforts and satisfactions. These 
enter our accounts, transformed simply by means of factors 
called prices, including that important price called the rate 
of interest. By means of such price factors, we reach 
from these elements, first, the interactions which depend 
on~them, then the complete income and outgo accounts 
(containing the values not only of interactions, but of ef- 



Sec. 6] VARIATIONS OF INCOME 131 

forts and satisfactions as well), and then the capital ac- 
counts (containing the discounted values of the items in the 
income accounts). 

To recapitulate in a few words the nature of capital and 
income, we may say that those parts of the material uni- 
verse which at any time are under the dominion of man, 
constitute his capital-wealth ; its ownership, his capital- 
property; its value, his capital- value. Capital-value im- 
plies anticipated income, which consists of a stream of bene- 
fits or its value. When values are considered, the causal 
relation is not from capital to income, but from income to 
capital ; not from present to future, but from future to pres- 
ent. In other words, the value of capital is the discounted 
value of the expected income. The fluctuations of this 
capital-value will, barring chance, be equal and opposite to 
the divergencies of " income taken out " from "interest ac- 
crued."' When the influence of chance is included, there 
will be in addition to these fluctuations still others which 
mirror the successive changes in the outlook for future 
income. 



CHAPTER VIII 

THE EQUATION OF EXCHANGE 

§ i. Introductory 

We have now finished the first great division of our sub- 
ject — a study of the foundation stones of Economics and 
how they fit together. These foundation stones are wealth, 
property, benefits, costs, capital, and income. Our study 
has so far consisted in pointing out the nature and rela- 
tions between these various concepts, and particularly be- 
tween capital and income. 

All of these relations find expression by means of prices. 
By prices, as we have seen, a miscellaneous collection of 
goods may be translated into a homogeneous mass of money- 
values. Only by such reduction to a common money basis 
are capital and income accounts possible. Capital accounts 
and income accounts are groups of heterogeneous elements re- 
duced to common terms by means of prices. But in all the 
capital and income accounts to which reference has thus far 
been made, and in all our previous discussions, we have 
taken prices for granted. We have, in other words, started 
out in our investigations upon the assumption that prices 
were fixed and known. But inasmuch as prices themselves 
are the outcome of economic forces, they must in turn be 
made the subject of analysis, and we must consequently 
now take up the second part of our task, which consists in 
discovering the principles that determine prices. 

If one were to ask how the price of wheat is determined, 

132 



Sec. i] THE EQUATION OF EXCHANGE 1 33 

the immediate answer would probably be : By supply and 
demand. This answer, though correct so far as it goes, is 
superficial. It is well to be on one's guard against glib 
phrases which are so often substituted for real analyses. 
" Supply and demand " is such a phrase. A long time ago, 
when economics consisted rather of glib phrases than of real 
analyses, a critic of the study said, " If you want to make 
a first-class economist, catch a parrot and teach him to say 
' supply and demand ' in response to every question you 
ask him. What determines wages? Supply and demand. 
What determines the distribution of wealth? Supply and 
demand." In every instance the answer is right, but it 
explains nothing. We must discover the forces which 
determine supply and demand. In so doing we shall learn 
that to determine the price even of one simple commodity, 
like wheat, involves practically all the principles of economic 
science. 

We are now ready to undertake — not the full study of 
the supply and demand of any article — but one of the im- 
portant forces underlying the supply and demand of all 
articles. That force is the purchasing power of money, a 
force as subtle as it is omnipresent. As every price is ex- 
pressed in money, it is evident that the willingness to take 
or give a certain amount of any article at a given price in 
money depends on the willingness to give or take a certain 
amount of money in exchange. This willingness to give or 
take money depends on the purchasing power of money over 
other things. Will a man pay ten cents for a pound of sugar ? 
That depends on whether or not he wants the sugar more 
than something else purchasable with the ten cents. The 
man, in other words, balances in his mind the sugar and the 
money — the latter standing in his mind for any goods he 
could spend it for. If the purchasing power of money is 
high, he will conceive so high a regard for money as to be 
reluctant to part with a given amount of it for a given quan- 
tity of sugar, i.e., he will be willing to pay only a low price 



134 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

for sugar. The seller, on the other hand, is more eager to 
take a unit of money when it has a high purchasing power, 
i.e., he is more willing to take a low price for sugar. Hence, 
if in a given year money has a high purchasing power, the 
price of sugar will be low. We see then that the prices 
of particular articles will tend to be low if money has a high 
purchasing power ; that is, if the prices of articles in general 
are low. It is therefore clear that the money price of every 
particular commodity depends partly on the prices of other 
commodities, i.e., on the general level of prices; just as the 
actual height reached by a particular wave of the sea depends 
partly on the general level of the ocean. 

The phrases " the purchasing power of money " and " the 
general level of prices " are reciprocal. To say that the pur- 
chasing power of money is high or low is the same thing as to 
say that the general level of prices is low or high, respec- 
tively. If the price level is doubled, the purchasing power 
of money will be halved, and vice versa. 

It is possible to study the general level of prices inde- 
pendently of particular prices, just as it is possible to study 
the general tides of the ocean independently of its particular 
waves. Moreover, it is not only more logical to study the 
general price level first, but this order of study has also the 
advantage of acquainting us as early as possible with the 
nature of money. Therefore, before we attempt to explain 
even the price of wheat in particular, we shall first take up 
the study of prices in general. 

In practice, money is a most convenient device, but in 
theory it is always a stumbling-block to the student of 
economics, who is exceedingly prone to misunderstand its 
functions. At the beginning of this book we pointed out 
some of the imagined functions of money that do not 
belong to it. We are now in a position to ask : What are 
the real functions of money ? 



Sec 2] THE EQUATION OF EXCHANGE 1 35 

§ 2. The Nature of Money 

We define money as goods generally acceptable in exchange 
for other goods. The facility with which it may thus be ex- 
changed, or its general acceptability, is the chief character- 
istic of money. The general acceptability may be reenforced 
by law, the money thus becoming " legal tender" {i.e., money 
which may be legally tendered or offered by a debtor to his 
creditor as a means of discharging his obligations and which 
the creditor must accept). But such reenforcement is not es- 
sential. All that is necessary in order that any good may 
be money is that general acceptability shall attach to it. 
On the frontier, without any legal sanction, money is some- 
times gold dust or gold nuggets. In the colony of Virginia 
it was tobacco. Among the Indians in New England it was 
wampum. 

How does it happen that these things come into use as 
money ? If we consider, for instance, the tobacco money of 
the Virginia colony before metallic money came in from 
Europe, it is not difficult to see how (in all probability) it 
first became money. When a man in Virginia had a particu- 
lar commodity to sell, say a piece of land, and he looked 
about for a purchaser, he may have found a man who wanted 
that piece of land and sought to make a trade with him. 
He found this man willing, let us suppose, to take that piece 
of land in exchange for cattle, slaves, jewelry, musical in- 
struments, etc., or for collections of various articles, but the 
would-be vendor wanted none of these things. Under these 
circumstances, we may suppose the proposed purchaser of 
the land to have said, " I have a lot of tobacco, which I will 
give you for the land," and the landowner to have replied, 
" I do not smoke; I do not want the tobacco." We may 
then suppose the purchaser to have said : " But tobacco is 
easily exchanged. Many people want it. It is so easy to 
carry and to keep that you will find no difficulty in disposing 
of it. Will you not take it temporarily, and, instead of smok- 



136 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

ing it yourself, rind somebody to take it in trade ? " Where- 
upon the landowner sells his land for the tobacco — not in 
order to use the tobacco himself, but with the thought of 
selling it to some smoker. When, however, he sets about 
finding the smokers in the community, he may have some 
difficulty in disposing of this tobacco, just as did the previ- 
ous owner. But he can then follow the example of the pre- 
vious owner, i.e., find somebody who has the things that he 
wants, and whom he can induce to take the tobacco tem- 
porarily. In this way the tobacco may pass through many 
hands, in each of which it rests only temporarily before it is 
passed on. Gradually, in this manner, it becomes custom- 
ary to take tobacco just for the purpose of passing it on, and 
not for the purpose of smoking it at all ; and after a time it 
is even prepared in a way not adapted to smoking, but con- 
venient for passing on. At last everybody takes the tobacco 
simply because everybody expects others to take it ; every- 
body gets it only to get rid of it. It is then said to circulate 
as a medium of exchange. We have no history of how to- 
bacco or anything else actually became money, but it was 
doubtless in some such way that money originated and that 
such a commodity as gold has finally survived as the most 
important form of money. Gold is easily transportable and 
is durable. People who did not want it for ornaments took 
it to sell to people who did want it for ornaments ; and after 
a while it came to be coined for the purpose of being handed 
on. At first a number of different things were used simul- 
taneously as money ; but one thing was found to be much 
more convenient than the others, and became the money 
par excellence of the community. 

There are various degrees of exchangeability which must 
be transcended before we arrive at real money. Of all kinds 
of goods, one of the least exchangeable is real estate. It is 
often difficult to find a person who wants to buy a particular 
piece of real estate. A mortgage on real estate is one degree 
more exchangeable. Yet even a mortgage is less exchange- 



Sec. 2] THE EQUATION OF EXCHANGE 1 37 

able than a well-known and safe corporation security ; and 
a corporation security is less exchangeable than a govern- 
ment bond. In fact, persons not infrequently buy govern- 
ment bonds as merely temporary investments, intending to 
sell them again as soon as permanent investments yielding 
better returns are obtainable. One degree more exchange- 
able than a government bond is a time bill of exchange ; 
one degree more exchangeable than a time bill of exchange 
is a sight draft ; while a check is almost as exchangeable as 
money itself. Yet no one of these is really money, for none 
of them is " generally acceptable." 

If we confine our attention to present and normal condi- 
tions, and to those means of exchange which either are 
money or most nearly approximate it, we shall find that 
money itself belongs to a general class of goods which we may 
call " currency " or " circulating media." Currency may 
be any kind of goods which, whether generally acceptable 
or not, does actually, for its chief purpose and use, serve as 
a means of exchange. 

Currency consists of two chief classes : (1) money ; (2) 
bank deposits, which will be treated fully in the next chap- 
ter. By means of checks, bank deposits serve as a means of 
payment in exchange for other goods. A check is the evi- 
dence of the transfer of bank deposits. It is acceptable to 
the payee only by his consent. It would not be generally 
accepted by strangers. Yet by checks, bank deposits, even 
more than money, do actually serve as a medium of ex- 
change. In this country bank deposits subject to check, or, 
as they are sometimes called, " deposit currency," are by far 
the most important kind of currency or circulating media. 

But although a bank deposit transferable by check is 
included in circulating media, it is not money. A bank note, 
on the other hand, is both circulating medium and money. 
Between these two lies the final line of distinction separat- 
ing what is money and what is not. The line is delicately 
drawn, especially in the case of such checks as cashier's 



138 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

checks or certified checks. For the latter are extremely 
similar, in respect to acceptability, to bank notes. Each is 
a demand liability on a bank, and each confers on the holder 
the right to draw money. Yet while a bank note is generally 
acceptable in exchange, a check is acceptable only by special 
consent of the payee. Real money is what a payee accepts 
without question, because he is induced to do so by " legal 
tender " laws or by a well-established custom. 

Of real money there are two kinds: primary and fidu- 
ciary. Money is called primary if it is a commodity which 
has just as much value in some use other than money as it 
has in monetary use ; that is, primary money is a commodity 
which has its full value even if it is not used as money or 
even if it is changed to a form in which it will not circulate 
as money. For instance, gold coins in the United States are 
primary money, since their value will be undiminished even 
if they are melted into gold bullion. In the same way, the 
tobacco money of Virginia in old days was primary, having 
as much value as tobacco as it had as money. Fiduciary 
money, on the other hand, is money the value of which de- 
pends partly or wholly on the confidence that the owner can 
exchange it for money, or at any rate for other goods, e.g., 
for primary money at a bank or government office or for 
discharge of debts or purchase of goods of merchants. For 
instance, a silver dollar in the United States is fiduciary 
money, since it is worth a dollar only because of the public 
confidence that the government will take it in taxes and the 
people in discharge of debts and for other purposes on equal 
terms with a dollar of gold. If a silver dollar be melted 
into bullion, it will, unlike the gold dollar, lose a large part 
of its value. That is, the bullion in a silver dollar is not 
worth a dollar ; it is only worth about forty cents. Our 
other silver coins are worth as bullion even less in propor- 
tion to their value as money, and our nickel and bronze coins 
are worth still less in proportion. Bank notes, government 
notes, and other forms of paper money are still more striking 



Sec. 2] 



THE EQUATION OF EXCHANGE 



139 



examples of fiduciary money, being practically worthless as 
paper, but having a high value as money, owing to the con- 
fidence that they can be exchanged for gold at the banks or 
the government treasury. The larger part of the money in 
use in the United States is fiduciary money, the chief ex- 
amples being silver dollars, fractional silver, minor coins, 
silver certificates, gold certificates, government notes (nick- 
named "greenbacks"), and bank notes. The exact nature 
of these various kinds of money constitutes a subject outside 
the purpose of this book. The student can, however, learn 
much as to their nature for himself, by reading the inscrip- 
tions on the various forms of money, which, from time to 
time, pass through his hands. 

The qualities of primary money which make for exchange- 
ability are numerous. The most important are portability, 
durability, and divisibility. The chief quality of fiduciary 
money, which makes it exchangeable, is its redeemability in 
primary money, or else 
its imposed character of 
" legal tender." 

Figure 8 indicates the 
classification of all circu- 
lating media in the 
United States. It shows 
that the total amount of 
circulating media is about 
eight and one half bil- 
lions, of which about 
seven billions are bank 
deposits subject to check, 
and one and one half 
billions, money ; and that 

of this one and one half billions of money one billion is 
fiduciary money and only about half a billion primary 
money. 

In the present chapter we shall exclude the consideration 



BANK 
DEPOSITS. 


FIDUCIARY 
MONEY. 


SEVEN 
BILLIONS. 


PRIMARY 

MONEY. 

ONE-WALF 

BILU ON. 


ONE 

BILLION 



Fig. 8. 



14O ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

of bank deposit or check circulation and confine our atten- 
tion to the circulation of money, primary and fiduciary. In 
the United States, the only primary money is gold coin. 
The fiduciary money includes token coins and paper money. 
Checks aside, we may classify exchanges into three groups : 
the exchange of goods against goods, or barter ; the exchange 
of money against money, or " changing " money ; and the 
exchange of money against goods, or purchase and sale. 
Only the last-named species of exchange involves what we 
call the circulation of money. The circulation of money 
signifies, therefore, the aggregate amount of its transfers 
against goods. All money held for circulation, i.e., all 
money, except what is in the vaults of the banks and of the 
United States government, is called money in circulation. 

§ 3. The Equation of Exchange Arithmetically Expressed 

If we overlook for the present the influence of checks, we 
may say that the price level depends on only three sets of 
causes: (1) the quantity of money in circulation; (2) its 
" efficiency " or velocity of circulation (or the average num- 
ber of times a year money is exchanged for goods) ; and (3) 
the volume of trade (or amount of goods bought by money). 
The so-called " quantity theory " {i.e., the theory that prices 
vary proportionally to money) has often been incorrectly 
formulated, but it is correct in the sense that the level of 
prices varies directly with the quantity of money in circula- 
tion, provided the velocity of circulation of that money and 
the volume of trade effected by means of it are not changed. 
This theory will be made clearer by the equation of exchange, 
which is now to be explained. 

The equation of exchange is a statement, in mathematical 
form, of the total transactions effected in a certain period 
in a given community. It is obtained simply by adding 
together the equations of exchange for all individual trans- 
actions. Suppose, for instance, that a person buys 10 



Sec. 3] THE EQUATION OF EXCHANGE 141 

pounds of sugar at 7 cents per pound. This is an exchange 
transaction, in which 10 pounds of sugar have been regarded 
as equivalent to 70 cents, and this fact may be expressed 
thus : 70 cents = 10 pounds of sugar multiplied by 7 cents 
a pound. Every other sale and purchase may be expressed 
similarly, and by adding them all together we get the equa- 
tion of exchange for a certain period in a given community. 
During this period, however, the same money may serve, 
and usually does serve, for several transactions. For that 
reason the left or money side of the equation is of course 
greater than the total amount of money in circulation. 

The equation has a goods side and a money side. The 
money side is the total money exchanged, and may be con- 
sidered as the product of the quantity of money multiplied 
by the rapidity of its circulation, i.e., the number of times it 
is exchanged for goods. This important magnitude, called 
the velocity of circulation or rapidity of turnover, means 
simply the quotient obtained by dividing the total money 
payments for goods in the course of a year by the average 
amount in circulation by which these payments are effected. 
This velocity of circulation in an entire community is a sort 
of average of the rates of turnover of different persons. 
Each person has his own rate of turnover which he can 
readily calculate by dividing the amount of money he ex- 
pends per year by the average amount he carries. The 
goods side of the equation is made up of the quantities of 
goods multiplied by their respective prices. 

Let us begin with the money side. If the number of 
dollars in a country is 5,000,000, and the velocity of circu- 
lation of these dollars is twenty times per year, then the 
total amount of money expended (for goods) during any 
year is $5,000,000 times twenty, or $100,000,000. This is 
the money side of the equation of exchange. 

Since the money side of the equation is $100,000,000, the 
goods side must be the same. For if $100,000,000 has been 
spent for goods in the course of the year, then $100,000,000 



142 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

worth of goods must have been sold in that year. In order 
to avoid the necessity of writing out the quantities and 
prices of the innumerable varieties of goods which are actu- 
ally exchanged, let us assume for the present that there are 
only three kinds of goods — bread, coal, and cloth ; and 
that the sales are : — 

200,000,000 loaves of bread at $ .10 a loaf, 
10,000,000 tons of coal at 5.00 a ton, and 
30,000,000 yards of cloth at 1.00 a yard. 

The value of these transactions is evidently $100,000,000, — 
i.e., $20,000,000 worth of bread plus $50,000,000 worth of 
coal plus $30,000,000 worth of cloth. The equation of ex- 
change, therefore, is as follows : — 

$5,000,000X20 times a year 

= 200,000,000 loaves X $ .10 a loaf 
+ 10,000,000 tons X 5.00 a ton 
+ 30,000,000 yards X 1. 00 a yard. 

This equation contains on the money side two magnitudes, 
viz., (1) the quantity of money, and (2) its velocity of cir- 
culation ; and on the goods side two groups of magnitudes 
in two columns, viz., (1) the quantities of goods exchanged 
(loaves, tons, yards), and (2) the prices of these goods ($.10 
per loaf, $5.00 per ton, and $1.00 per yard). The equation 
shows that these four sets of magnitudes are mutually re- 
lated. Because this equation must be fulfilled, the prices 
must bear a relation to the three other sets of magnitudes — 
quantity of money, rapidity of circulation, and quantities 
of goods exchanged. Consequently, these prices must, as a 
whole, vary proportionally with the quantity of money and 
with its velocity of circulation, and inversely with the quan- 
tities of goods exchanged. 

Suppose, for instance, that the quantity of money were 
doubled, while its velocity of circulation and the quantity of 



Sec. 3] THE EQUATION OF EXCHANGE 1 43 

goods exchanged remained the same. Then it would be 
quite impossible for prices to remain unchanged. The 
money side would now be $10,000,000 X 20 times a year, or 
$200,000,000 ; whereas, if prices should not change, the 
goods would remain $100,000,000 and the equation would 
be violated. Since exchanges, individually and collectively, 
always involve an equivalent quid pro quo, the two sides 
must be equal. Not only must purchases and sales be equal 
in amount — since every article bought by one person is 
necessarily sold by another — but the total value of goods 
sold must equal the total amount of money exchanged. 
Therefore, under the given conditions, prices must change 
in such a way as to raise the goods side from $100,000,000 
to $200,000,000. This doubling may be accomplished by 
an even or an uneven rise of prices, but some sort of a rise 
of prices there must be. If the prices rise evenly, they will 
evidently all be exactly doubled, so that the equation 
will read : — 

$10,000,000 X 20 times a year 

= 200,000,000 loaves X $ -20 per loaf 
-+- 10,000,000 tons X 10.00 per ton 
+ 30,000,000 yards X 2.00 per yard. 

If the prices rise unevenly, the doubling must evidently be 
brought about by compensation ; if some prices rise by 
less than double, others must rise by enough more than 
double to exactly compensate. 

But whether all prices increase uniformly, each being ex- 
actly doubled, or some prices increase more and some less 
(so as still to double the total money-value of the goods pur- 
chased) , the prices are doubled on the average. This proposi- 
tion is usually expressed by saying that the " general level 
of prices " is raised twofold. From the mere fact, therefore, 
that the money spent for goods must equal the quantities of 
those goods multiplied by their prices, it follows that the level 



144 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

of prices must rise or fall according to changes in the quan- 
tity of money, unless there are changes in its velocity of 
circulation or in the quantities of goods exchanged. 

If changes in the quantity of money affect prices, so will 
changes in the other factors — quantities of goods and 
velocity of circulation — affect prices, and, in the case of a 
change in the velocity of circulation, in a very similar man- 
ner to that seen in the case of a change in the quantity of 
money. Thus a doubling in the velocity of circulation of 
money will double the level of prices, provided the quantity 
of money in circulation and the quantities of goods ex- 
changed for money remain as before. The equation will 
change (from its original form) to the following : — 

$5,000,000 X 40 times a year 

= 200,000,000 loaves X $ .20 a loaf 
+ 10,000,000 tons X 10.00 a ton 
+ 30,000,000 yards X 2.00 a yard; 

or else the equation will assume a form in which some of the 
prices will more than double, and others less than double 
by enough to preserve the same total value of the sales. 

Again, a doubling in the quantities of goods exchanged 
will not double, but halve, the height of the price level, 
provided the quantity of money and its velocity of circula- 
tion remain the same. Under these circumstances the 
equation will become : — 

$5,000,000 X 20 times a year 

= 400,000,000 loaves X $ -05 a loaf 
+ 20,000,000 tons X 2.50 a ton 
-f 60,000,000 yards X .50 a yard; 

or else it will assume a form in which some of the prices are 
more than halved, and others less than halved, so as to 
preserve the equation. 



Sec. 4] 



THE EQUATION OF EXCHANGE 



145 



Finally, if there is a simultaneous change in two or all of 
the three influences, i.e., quantity of money, velocity of 
circulation, and quantities of goods exchanged, the price 
level will be a compound or resultant of these various in- 
fluences. If, for example, the quantity of money is doubled, 
and its velocity of circulation is halved, while the quantity 
of goods exchanged remains constant, the price level will be 
undisturbed. Likewise it will be undisturbed if the quan- 
tity of money is doubled and the quantity of goods is 
doubled, while the velocity of circulation remains the same. 
To double the quantity of money, therefore, is not always 
to double prices. We must distinctly recognize that the 
quantity of money is only one of three factors, all equally 
important in determining the price level. 



§ 4. The Equation of Exchange Mechanically Expressed 

The equation of exchange has now been expressed by an 
arithmetical illustration. It may be represented visually 
by a mechanical illustration. Such a representation is em- 
bodied in Figure 9. This represents a mechanical balance 



ZK 





in equilibrium, the two sides of which symbolize respectively 
the money side and the goods side of the equation of ex- 
change. The weight at the left, symbolized by a purse, 
represents the money in circulation; its leverage or dis- 
tance from the fulcrum at which it (the purse) is hung 
represents the efficiency of this money, or its velocity of 
circulation. The product of the weight by its leverage 



146 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

is exactly balanced by corresponding magnitudes on the 
opposite side. On the right side are three weights : bread, 
coal, and cloth, symbolized respectively by a loaf, a coal 
scuttle, and a roll of cloth. The leverage, or distance of 
each from the fulcrum, represents its price. In order that 
the leverages at the right may not be inordinately long, we 
have found it convenient to reduce the unit of measure of 
coal from tons to hundredweights, and that of cloth from 
yards to feet, and consequently to enlarge correspondingly 
the number of units (the measure of coal changing from 
10,000,000 tons to 200,000,000 hundredweights, and that 
of the cloth from 30,000,000 yards to 90,000,000 feet). 
The price of coal in the new unit per hundredweight becomes 
25 cents per hundredweight and that Of cloth in feet becomes 
33^ cents per foot. 

If, now, we assume that the velocity of circulation of 
money remains the same {i.e., that the left leverage neither 
lengthens nor shortens), and that the trade remains the 
same {i.e., that the weights at the right neither increase 
nor decrease), then it follows that the increase of the money 
at the left will require a lengthening of one or more of the 
leverages at the right, representing prices. If these prices 
increase uniformly, they will increase in the same ratio as 
the increase in money ; if they do not increase uniformly, 
some will increase more and some less than this ratio, 
maintaining an average. Likewise it is evident that if the 
velocity of circulation of money increases, i.e., if the leverage 
at the left lengthens, and if the money in circulation (the 
purse) and the trade (the various weights) remain the 
same, there must be an increase in prices (lengthening of 
the leverages at the right). Again, if there is an increase 
in the volume of trade (represented by an increase in weights 
at the right), and if the velocity of circulation of money 
(left leverage) and the quantity of money (left weight) re- 
main the same, there must be a decrease in prices (right 
leverages). 



Sec. 4] THE EQUATION OF EXCHANGE • 1 47 

In general, any change in one of these four sets of mag- 
nitudes must be accompanied by such a change or changes 
in one or more of the other three as shall maintain 
equilibrium. 

As we are interested in the average change in prices 
rather than in the prices individually, we may simplify this 
mechanical representation by hanging all the right-hand 
weights at one average point, so that the leverage shall 
represent the average of prices. This average of 10 cents 
per loaf, 25 cents per hundredweight, and 33I cents per foot 
is found by dividing the total value (10 cents times 200 
million loaves plus 25 cents times 200 million hundred- 
weight plus 33^ cents times 90 million feet, or $100,000,000) 
by the total number of units (200 million plus 200 million 
plus 90 million, or 490 million), which is $100,000,000 -f- 
490,000,000, or 20.4 cents per unit. This leverage is a so- 
called " weighted average " of the three original leverages, 
the weights being literally the weights hanging at the right. 

This averaging of prices is represented in Figure 10, 





Fig. 10. 

which visualizes the fact that the average price of goods 
(right leverage) varies directly with the quantity of money 
(left weight), directly with its velocity of circulation (left 
leverage), and inversely with the volume of trade (right 
weight). 



148 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

§ 5. The Equation of Exchange Algebraically Expressed 

To put these relations in general terms, we may use an 
algebraic formula : — 

MV = p Q 
+ P'Q' 

+ P"Q" 
+ etc. 

The quantity of money in circulation we call M , and the 
velocity of circulation, V. Then M V equals the amount of 
money expended for goods during the year. On the other 
side, p is the price of any good, and Q its quantity ; p' the 
price of another, and Q' its quantity ; and so on. If in this 
equation M is doubled (and V and the Q's remain un- 
changed) then the p's will, on the average, be doubled ; if 
V is doubled (and M and the <2's are unchanged), the p's 
will be doubled also ; while if the Q's are doubled (and M 
and V are unchanged), the p's will be halved. 

The right side of this equation is the sum of terms of 
the form pQ — a price multiplied by a quantity bought. 
It is customary in mathematics to abbreviate a sum of 
terms (all of which are of the same form) by using " 2 " 
(the Greek letter sigma, which is the equivalent of the Eng- 
lish letter " S," the initial letter of sum) as a symbol of 
summation. This symbol does not signify a magnitude as 
do the symbols M, V, p, Q, etc. It signifies merely the 
operation of addition, and should be read " the sum of terms 
of the following type." The equation of exchange may 
therefore be written : — 

MV= tpQ. 

We may, if we wish, further simplify the right side by 
writing it in the form PT, where P is the average of all the 
p's, and T is the sum of all the Q's. P then represents in 
one magnitude the level of prices, and T represents in one 



Sec. 6] THE EQUATION OF EXCHANGE 1 49 

magnitude the volume of trade. The equation thus 
simplified (MV = PT) is the algebraic interpretation of 
the mechanical illustration given in Figure 10, where all the 
goods, instead of being hung separately, as in Figure 9, 
were combined and hung at an average point representing 
their average price. 

§ 6. The "Quantity Theory of Money " 

To recapitulate, we find then that, under the conditions 
assumed, the price level varies, (1) directly as the quantity 
of money in circulation (M), (2) directly as the velocity of 
its circulation (V), (3) inversely as the volume of trade done 
by it (T). The first of these three relations is the most 
important. It constitutes the "quantity theory of money." 

So important is this principle, and so bitterly contested 
has it been, that we shall illustrate it further. By " the 
quantity of money " is meant the number of dollars (or 
other given monetary units) in circulation. This number 
may be changed in several ways, of which the following 
three are most important. A statement of them will serve 
to picture to our mind the meaning of the conclusions we 
have reached and to reveal the fundamental peculiarity of 
money on which they rest. 

As a first illustration, let us suppose the government to 
double the denominations of all money ; that is, let us sup- 
pose that what has been hitherto a half dollar is hence- 
forth called a dollar, and that what has been hitherto a 
dollar is henceforth called two dollars. Evidently the num- 
ber of " dollars " in circulation will then be doubled ; and 
the price level, measured in terms of the new " dollars," 
will be double what it would otherwise be. Every one will 
pay out the same coins as if no such law were passed. But he 
will, in each case, be paying twice as many " dollars." For 
example, if $3 formerly had to be paid for a pair of shoes, 
the price of this same pair of shoes will now become $6. 



150 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

Thus we see how the nominal quantity of money affects 
price levels. 

A second illustration may be found by supposing a 
reduction in the weight of coins. Suppose a government 
cuts each dollar in two, coining the halves into new " dol- 
lars " ; and, recalling all paper notes, replaces them with 
double the original number — two new notes for each old 
one of the same denomination. In short, suppose money 
not only to be renamed, as in the first illustration, but also 
reissued. Prices in the debased coinage will again be doubled 
just as in the first illustration. The subdivision and re- 
coinage is an immaterial circumstance, unless it be carried 
so far as to make counting difficult, and thus to interfere 
with the convenience of money. Wherever a dollar had been 
paid before debasement, two dollars — i.e., two of the old 
halves coined into two of the new dollars — will now be 
paid instead. 

In the first illustration, the increase in quantity was 
simply nominal, being brought about by renaming coins. 
In the second illustration, besides renaming, the further 
fact of recoining is introduced. In the first case, the num- 
ber of actual pieces of money of each kind was unchanged, 
but their denominations were doubled. In the second case, 
the number of pieces is also doubled by splitting each coin 
and reminting it into two coins, each of the same nominal 
denomination as the original whole of which it is the half, 
and by similarly doubling the paper money. 

For a third illustration, suppose that, instead of doubling 
the number of dollars by splitting them in two and recoin- 
ing the halves, the government duplicates each piece of 
money in existence and presents the duplicate to the pos- 
sessor of the original. (We must in this case suppose, 
further, that there is some effectual bar to prevent the 
melting or exporting of money. Otherwise the quantity of 
money in circulation will not be doubled ; much of the in- 
crease will escape.) If the quantity of money is thus 



SEC. 6] THE EQUATION OF EXCHANGE 151 

doubled, prices will also be doubled just as truly as in the 
second illustration, in which there were exactly the same 
number of coins as now under consideration as well as the 
same denominations. The only difference between the 
second and the third illustrations will be in the size and 
weight of the coins. The weights of the individual coins, 
instead of being reduced, will remain unchanged ; but their 
number will be doubled. This doubling of corns must have 
the same effect as the fifty per cent debasement ; that is, 
it must have the effect of doubling prices. 

The force of the third illustration becomes even more 
evident if, in accordance with the presentation of the great 
economist Ricardo, we pass back by means of a seigniorage 
from the third illustration to the second. That is, after 
duplicating all money, let the government subtract half of 
each coin, thereby reducing the weight to that of the debased 
coinage in the second illustration, and removing the only 
point of distinction between the two. This " seigniorage " 
or charge for coinage made by the sovereign will not affect 
the money value of the coins, so long as their number remains 
unchanged. Prices will remain at exactly the same level as 
before the abstraction of seigniorage. Thus to double the 
quantity of money will double prices in whatever way the 
doubling may be brought about, — unless there should 
occur at the same time some change in the velocity of 
circulation of money or in the volume of trade. 

There are many historical instances of raising the prices 
by inflating the currency. At present, Argentina has an 
inflated paper currency, and prices in paper pesos are a 
little more than double the prices in the original gold pesos. 

The quantity theory, then, asserts that (provided ve- 
locity of circulation and volume of trade are unchanged) 
if we increase the number of dollars, whether by renaming 
coins, by cutting them in two, by duplicating them, or by 
any other means, prices will be increased in the same pro- 
portion. It is the number, and not the weight, that is 



152 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

essential. This fact needs great emphasis. It is a fact 
which differentiates money from all other goods and ex- 
plains the peculiar manner in which its purchasing power 
is related to other goods. The desirability of sugar depends 
upon its sweetening power, which is a specific quality in 
the sense that a given weight of sugar, such as a pound, 
always possesses the same sweetening power. The desir- 
ability of money, on the other hand, depends merely on its 
purchasing power; but purchasing power is not a specific 
quality of gold or of other money, for we cannot say that a 
given quantity of gold, such as an ounce, always possesses 
the same purchasing power. If the quantity of sugar is 
changed from 1,000,000 pounds to 1,000,000 hundredweight, 
it does not follow that a hundredweight will have the value 
previously possessed by a pound, for the sweetening power 
of a hundredweight cannot be the same as that of a pound. 
But if the money in circulation is changed from 1,000,000 
units of one weight to 1,000,000 units of another weight, 
the value of each unit will remain unchanged, for we have 
seen from the equation of exchange that its purchasing 
power would be unchanged. 

The quantity theory of money thus rests, ultimately, 
upon the fundamental peculiarity which money alone of all 
goods possesses — the fact that it has no power to satisfy 
human wants, but only the power to purchase things which 
do have such satisfying power. 



CHAPTER IX 

DEPOSIT CURRENCY 

§ i. The Mystery of Circulating Credit 

We are now ready to explain the nature of bank-deposit 
currency, or circulating credit. Credit, in the sense here 
employed, is the claim of a creditor against a debtor. 
Bank deposits subject to check are the claims of the credi- 
tors of a bank against the bank, by virtue of which they 
may, on demand, draw by check specified sums of money 
from the bank. Since no other kind of bank deposits will 
be considered by us, we shall usually refer to " bank de- 
posits subject to check " simply as " bank deposits." 
They are also called " circulating credit." 

It is to be observed that bank checks are merely 
evidences of rights to draw bank deposits or to trans- 
fer them. The checks themselves are not the ultimate 
currency. It is the bank deposits themselves, or credit 
balances on the books of the banks, that constitute the 
ultimate currency. Nor are these deposits actual money. 
They are not money, because they are not generally 
acceptable ; they always require the special consent of the 
payee. But they are currency, because their chief purpose 
and use is to act as a medium of exchange. Closely 
analogous to checks are post office orders and money orders 
issued by express companies. They are distinguishable 
only by two facts : that they are not issued by ordinary 

153 



154 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. IX 

banks, and that they originate in particular deposits of 
money or the equivalent of money. For this reason, and 
because they are not of great importance, we prefer to 
place them in the same category with bank checks rather 
than to place them in a separate class, which otherwise 
they might occupy. 

It is in connection with the transfer of bank deposits 
that there arises that so-called " mystery of banking " 
called circulating credit. Many persons, including some 
economists, have supposed that credit is a special form of 
wealth which may be created out of whole cloth, as it were, 
by a bank. Others have maintained that credit has no 
foundation in actual wealth at all, but is a kind of unreal 
and inflated bubble with a precarious if not wholly illegiti- 
mate existence. As a matter of fact, bank deposits are as 
easy to understand as bank notes, and what is said in this 
chapter of bank deposits may in substance be taken as true 
also of bank notes. The chief difference is a formal one, 
the notes circulating from hand to hand, while the deposit 
currency circulates only by means of special orders called 
"checks." 

To understand the real nature of bank deposits, let us 
imagine a hypothetical institution — a kind of primitive 
bank existing mainly for the sake of deposits and the safe- 
keeping of actual money. The original bank of Amster- 
dam was somewhat like the bank we are now imagining. 
In such a bank a number of people deposit $100,000 in gold, 
each accepting a receipt for the amount of his deposit. If 
this bank should issue a " capital account " or statement, 
it would show $100,000 in its vaults and $100,000 owed to 
depositors, as follows : — 

Assets Liabilities 

Gold $100,000 Due depositors . . $100,000 

The right-hand side of the statement is, of course, made 
up of smaller amounts owed to individual depositors. 



Sec. i] DEPOSIT CURRENCY 1 55 

Assuming that there is owed to A $10,000, to B $10,000, 
and to all others $80,000, we may write the bank statement 
as follows : — 

Assets Liabilities 

Gold $100,000 Due depositor A . . $ 10,000 

Due depositor B . . 10,000 
Due other depositors . 80,000 



$100,000 $100,000 

Now assume that A wishes to pay B $1000. A could go 
to the bank with B, present certificates or checks for $1000, 
obtain the gold, and hand it over to B, who might then 
redeposit it in the same bank, merely handing it back 
through the cashier's window and taking a new certificate 
in his own name. Instead, however, of both A and B 
visiting the bank and handling the money, A might simply 
give B a check for $1000. The transfer in either case 
would mean that A's holding in the bank was reduced from 
$10,000 to $9000, and that B's was increased from $10,000 
to $1 1 ,000. The statement would then read : — 

Assets Liabilities 

Gold $100,000 Due depositor A . . $ 9,000 

Due depositor B . . 11,000 

Due other depositors . 80,000 

$100,000 $100,000 

Thus the certificates, or checks, would circulate in place 
of cash among the various depositors in the bank. What 
really changes ownership, or " circulates," in such cases is 
the right to draw money. The check is merely the evidence 
of this right and of the transfer of this right from one per- 
son to another. 

In the case under consideration, the bank would be con- 
ducted at a loss. It would be giving the time and labor 
of its clerical force for the accommodation of its depositors, 
without getting anything in return. But such a hypo- 



156 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

thetical bank would soon find — much as did the bank of 
Amsterdam — that it could make profits by lending at 
interest some of the gold on deposit. This could not offend 
the depositors; for they do not expect or desire to get 
back the identical gold they deposited. What they want 
is simply to be able at any time to obtain the same amount 
of gold. Since, then, their arrangement with the bank calls 
for the payment not of any particular gold, but merely of 
a definite amount, and that but occasionally, the bank 
finds itself free to lend out part of the gold that otherwise 
would lie idle in its vaults. To keep it idle would be a 
great and needless waste of opportunity. 

Let us suppose, then, that the bank decides to loan out 
half its cash. In this country this is usually done in ex- 
change for promissory notes of the borrowers. Now a loan 
is really an exchange of money for a promissory note which 
the lender — in this case the bank — receives in place of 
the gold. Let us suppose that so-called borrowers actually 
draw out $50,000 of gold. The bank thereby exchanges 
this money for promises, and its books will then read : — 

Assets Liabilities 

Gold $ 50,000 Due depositor A . . $ 9,000 

Promissory notes . . " 50,000 Due depositor B . . 11,000 

Due other depositors . 80,000 

$100,000 $100,000 

It will be noted that now the gold in bank is only $50,000, 
while the total deposits are still $100,000. In other words, 
the depositors now have more " money on deposit " than 
the bank has in its vaults ! But, as will be shown, this 
form of expression involves a popular fallacy, in the word 
" money." Something of equivalent value is behind each 
loan, but not necessarily money. 

Next, suppose the borrowers become, in a sense, lenders 
also, by redepositing the $50,000 of cash which they bor- 
rowed, in return for the right to draw out the same sum on 



Sec. iJ DEPOSIT CURRENCY 1 57 

demand, preferring to use the same in making payments 
by check rather than by money. In other words, suppose 
that after borrowing $50,000 from the bank, they lend it 
back to the bank. The bank's assets will thus be enlarged 
by $50,000, and its obligations (or credit extended) will be 
equally enlarged ; and the balance sheet will become : — 





Assets 




Liabilities 


Gold . 




$100,000 


Due depositor A . . $ 9,000 


Promissc 


)ry notes . . 


50,000 


Due depositor B . . 11,000 
Due other depositors . 80,000 
Due new depositors, 

i.e., the borrowers . 50,000 



$150,000 $150,000 

What happened in this case was the following : Gold 
was borrowed in exchange for a promissory note and then 
handed back in exchange for a right to draw. Thus the 
gold really did not budge ; but the bank received a promis- 
sory note and the depositor, a right to draw. Evidently, 
therefore, the same result would have followed if each bor- 
rower had merely handed in his promissory note and re- 
ceived, in exchange, a right to draw. As this operation 
most frequently puzzles the beginner in the study of bank- 
ing, we repeat the tables representing the conditions before 
and after these " loans," i.e., these exchanges of promissory 
notes for present rights to draw. 

BEFORE THE LOANS 

Assets Liabilities 

Gold $100,000 Due depositors . . . $100,000 

AFTER THE LOANS 

Gold $100,000 Due depositors . . . $150,000 

Promissory notes . . 50,000 

Clearly, therefore, the intermediation of the money in 
this case is a needless complication, though it may help to 



158 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

a theoretical understanding of the resultant shifting of 
rights and liabilities. Thus the bank may receive deposits of 
gold or deposits of promises to pay. In exchange for these 
promises it may give, or lend, either a right to draw, or 
gold — the same that was deposited by another customer. 
Even when the borrower has " deposited " only a promise 
to pay money, by fiction he is still held to have deposited 
money; and, like the original cash depositors, he is given 
the right to make out checks to draw out money. The 
total value of rights to draw, in whichever way arising, is 
termed "deposits." Banks more often lend rights to draw 
(or deposit rights) than actual cash, partly because of the 
greater convenience to borrowers, and partly because the 
banks wish to keep their cash reserves large, in order to 
meet large or unexpected demands. It is true that if a 
bank loans money, part of the money so loaned will be 
redeposited by the persons to whom the borrowers pay it 
in the course of business ; but it will not necessarily be 
redeposited in the same bank. Hence the average banker 
prefers that the borrower should not withdraw actual 
cash. 

Besides lending deposit rights, banks may also lend their 
own notes, called " bank notes." And the principle govern- 
ing bank notes is the same as the principle governing 
deposit rights. The holder simply gets a pocketful of bank 
notes • instead of a bank account. In either case the bank 
must always be ready to pay the note holder — to " redeem 
its notes " — as well as pay its depositors, on demand, 
and in either case the bank exchanges a promise for a 
promise. In the case of the note, the bank has exchanged 
its bank note for a customer's promissory note. The bank 
note carries no interest, but is payable on demand. The 
customer's note bears interest, but is payable only at a 
definite date. 

Assuming that the bank issues $50,000 of notes, the 
balance sheet will now become : — 



Sec. 2] DEPOSIT CURRENCY 1 59 

Assets Liabilities 

Gold $100,000 Due depositors . . $150,000 

Loans (promissory 

notes) 100,000 Due note holders . . 50,000 

$200,000 $200,OOJ 

We repeat that by means of credit the deposits and notes 
of a bank may exceed its cash. There would be nothing 
mysterious or obscure about this fact, if people could be 
induced not to think of banking operations as money 
operations. To so represent them is metaphorical and 
misleading. They are no more money operations than 
they are real estate transactions. A bank depositor, A, has 
not ordinarily " deposited money " ; and whether he has 
or not, he certainly cannot properly say that he " has 
money in the bank." What he does have is the bank's 
promise to pay money on demand. The bank owes him 
money. When a private person owes money, the creditor 
never thinks of saying that he has it on deposit in the 
debtor's pocket. 

The same principles of property which apply to bank 
deposits also apply to bank notes. There is wealth some- 
where behind the mutual promises, though in different 
degrees of accessibility. The note holder's promise is 
secured by his assets ; and the bank's promise is secured by 
the bank's assets. The note holder has " swapped " less- 
known credit for better-known credit. 

§ 2. The Basis of Circulating Credit 

If this fact is borne in mind, the reader will be able to 
conquer the doubt which may already have arisen in his 
mind — the doubt as to the legitimacy of the bank's pro- 
cedure in " lending some of its depositors' money." It 
cannot be too strongly emphasized that, in any balance 
sheet, the value of the liabilities rests on that of the assets. 
The deposits of a bank are no exception. We must not be 
misled by the fact that the cash assets may be less than 



l60 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. IX 

the deposits. When the uninitiated first learn that the 
number of dollars which note holders and depositors have 
the right to draw out of a bank exceeds the number of 
dollars in the bank, they are apt to jump to the conclusion 
that there is nothing behind the notes or deposit liabilities. 
Yet behind all these obligations there is always, in the case 
of a solvent bank, full value ; if not actual dollars, at any 
rate, dollars' worth of property. By no jugglery can the 
liabilities exceed the assets except in insolvency, and even 
in that case only nominally, for the true value of the lia- 
bilities (" bad debts ") will only equal the true value of the 
assets behind them. 

These assets, as already indicated, are, and ought to be, 
largely the notes of merchants, although, so far as the prin- 
ciples here discussed are concerned, they might be any 
property whatever. If they consisted in the ownership of 
real estate or other wealth in " fee simple," so that the 
tangible wealth which property always represents were 
clearly evident, all mystery would disappear. But the 
effect would not be different. Instead of taking grain, 
machines, or steel ingots on deposit, in exchange for the 
sums lent, banks prefer to take interest-bearing notes of 
corporations and individuals who own, directly or indirectly, 
grain, machines, and steel ingots ; and by the banking laws 
the banks are even compelled to take the notes instead of 
the ingots. The bank finds itself with liabilities which 
exceed its cash assets ; but this excess of liabilities is balanced 
by the possession of other assets than cash. These other 
assets of the bank are the liabilities of business men. 

This ultimate basis of the entire credit structure is kept 
out of sight, but the basis exists. Indeed, we may say that 
banking, in a sense, causes this visible, tangible wealth to 
circulate. If the acres of a landowner or the iron stoves of 
a stove dealer cannot circulate in literally the same way 
that gold dollars circulate, yet the landowner or stove 
dealer may give to the bank a note on which the banker 



Sec. 2] DEPOSIT CURRENCY l6l 

may base bank notes or deposits ; and these bank notes and 
deposits will circulate like gold dollars. Through banking, 
he who possesses wealth difficult to exchange can create a 
circulating medium based upon that wealth. He has only to 
give his note, for which, of course, his property is liable, get 
in return the right to draw, and lo ! his comparatively unex- 
changeable wealth becomes liquid currency. To put it crude- 
ly, banking is a device for coining into dollars land, stoves, 
and other wealth not otherwise generally exchangeable. 

It is interesting to observe that the formation of the great 
modern " trusts " has given a considerable impetus to de- 
posit currency; for the securities of large corporations are 
more easily used as " collateral security " for bank loans 
(where banks require the promissory notes to be in turn 
secured by " collateral ") than the stocks and bonds of 
small corporations or than partnership rights. 

We began by regarding a bank as substantially a co- 
operative enterprise, operated for the convenience and at 
the expense of its depositors. But, as soon as it reaches 
the point of lending money to X, Y, and Z on time, while 
itself owing money on demand, it assumes toward X, Y, 
and Z risks which the depositors would be unwilling to 
assume. To meet this situation, the responsibility and 
expense of running the bank are taken by a third class of 
people — stockholders — who are willing to assume the 
risk for the sake of the chance of profit. Stockholders, in 
order to guarantee the depositors against loss, put in some 
cash of their own. Their contract is, in effect, to make 
good any loss to depositors. Let us suppose that the stock- 
holders put in $50,000, viz., $40,000 in cash and $10,000 in the 
purchase of a bank building. The accounts now stand : — 

Assets Liabilities 

Gold $140,000 Due depositors . . $150,000 

Loans 100,000 Due note holders . . 50,000 

Building 10,000 Due stockholders . . 50,000 

$250,000 $250,000 

M 



1 62 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

The accounts as they now stand include the chief features 
of an ordinary modern bank — a so-called " bank of deposit, 
issue, and discount." 

§ 3. Banking Limitations 

We have seen that the assets must be adequate to meet 
the liabilities. We now should note that the form of the 
assets must be such as will insure meeting the liabilities 
promptly. Since the business of a bank is to furnish easily 
exchangeable property (cash or credit) in place of the 
" slower " property of its depositors, it fails of its purpose 
when it is caught with insufficient cash. Yet it makes 
profits partly by tying up its quick property, i.e., lending 
it out where it is less accessible. Its problem in policy is 
to tie up enough to increase its earnings, but not to tie up 
so much as to get tied up itself. So far as anything has 
yet been said to the contrary, a bank might increase in- 
definitely its loans in relation to its cash or in relation to its 
capital. If this were so, deposit currency could be indefi- 
nitely inflated. 

There are limits, however, imposed by prudence and 
sound economic policy on both these processes. Insol- 
vency and insufficiency of cash must both be avoided. As 
has been noted in Chapter III, insolvency is that condition 
which threatens when liabilities are extended with in- 
sufficient capital. Insufficiency of cash is that condition 
which threatens when liabilities are extended unduly rela- 
tively to cash, while insolvency is reached when the assets 
no longer cover the liabilities (to others than stockholders), 
so that the bank is unable to pay its debts. Insufficiency 
of cash is reached when, although the bank's total assets 
may be fully equal to its liabilities, the actual cash on 
hand is insufficient to meet the needs of the instant, and 
the bank is unable to pay its debts on demand. 

The less the ratio of the value of the stockholders' inter- 



Sec. 3] DEPOSIT CURRENCY 1 63 

ests to the value of all liabilities to others, the greater is the 
danger of insolvency ; the risk of insufficiency of cash is the 
greater, the less the ratio of the cash to the demand liabili- 
ties. In other words, the leading safeguard against insol- 
vency lies in a large capital and surplus, but the leading 
safeguard against insufficiency of cash lies in a large cash 
reserve. Insolvency proper may befall any business enter- 
prise. Insufficiency of cash relates especially to banks in 
their function of redeeming notes and deposits. 

Let us illustrate insufficiency of cash. In our bank's 
accounts as we left them there appeared cash to the extent 
of $140,000, and $200,000 of demand liabilities (deposits and 
notes). The managers of the bank may think this fund of 
$140,000 unnecessarily large, or the loans unnecessarily 
small. They may then increase their loans (extended to 
customers partly in the form of cash and partly in the form 
of deposit accounts) until the cash held by the bank is re- 
duced, say to $40,000, and the liabilities due depositors and 
note holders increased to $300,000. If, under these circum- 
stances, some depositor or note holder demands $50,000 
cash, immediate payment will be impossible. It is true that 
the assets still equal the liabilities. There is full value be- 
hind the $50,000 demanded ; but the understanding was 
that depositors and note holders should be paid in money on 
demand. Were this not a stipulation of the deposit con- 
tract, the bank might pay the claims thus made upon it by 
transferring to its creditors the promissory notes due it from 
its debtors ; or it might ask the customers to wait until it 
could turn these securities into cash. 

Since a bank cannot follow either of these plans, it tries, 
where insufficiency of cash impends, to forestall this condi- 
tion by " calling in " some of its loans, or if none can be 
called in, by selling some of its securities or other property 
for cash. But it happens unfortunately that there is a limit 
to the amount of cash which a bank can suddenly realize. 
No bank could escape failure if a large percentage of its note 



164 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

holders and depositors should simultaneously demand cash 
payment. The paradox of a run on a bank is well expressed 
by the case of the man who inquired of his bank whether it 
had cash available for paying the amount of his deposit, 
saying, " If you can pay me, I don't want it ; but if you 
can't, I do." Such was the situation in 1907 in Wall Street. 
All the depositors at one time wanted to be sure their money 
" was there." Yet it never is there all at one time. 

Since, then, insufficiency of cash is so troublesome a con- 
dition — so difficult to escape when it has arrived, and so 
difficult to forestall when it begins to approach — a bank 
must so regulate its loans and note issues as to keep on hand 
a sufficient cash reserve, and thus prevent insufficiency of 
cash from even threatening. It can regulate the reserve in 
various ways. For instance, it can increase its reserve rel- 
atively to its liabilities by " discounting " less freely — by 
raising the rate of discount and thus discouraging would-be 
borrowers, by outright refusal to lend or even to renew old 
loans, or by " calling in " loans subject to call. Reversely, 
it can decrease its reserve relatively to its liabilities by dis- 
counting more freely — by lowering the rate of discount 
and thus attracting borrowers. The more the loans in pro- 
portion to the cash on hand, the greater the profits, but the 
greater the danger also. In the long run a bank maintains 
its necessary reserve by means of adjusting the interest rate 
charged for loans. If it has few loans, and a reserve large 
enough to support loans of much greater volume, it will 
endeavor to extend its loans by lowering the rate of interest. 
If its loans are large, and it fears too great demands on the 
reserve, it will restrict the loans by a high interest charge. 
Thus by alternately raising and lowering the rate of interest, 
a bank keeps its loans within the sum which the reserve can 
support, but endeavors to keep them (for the sake of profit) 
as high as the reserve will support. 

If the sums owed to individual depositors are large, rela- 
tively to the total liabilities, the reserve should be propor- 



Sec. 4] DEPOSIT CURRENCY 1 65 

tionately large, since the action of a small number of deposi- 
tors can deplete it rapidly. The reserve in a large city of 
great banking activity needs to be greater in proportion to 
its demand liabilities than in a small town with infrequent 
banking transactions. No absolute numerical rule can be 
given. Arbitrary rules are often imposed by law. Banks 
in the United States, for instance, are required to keep a 
ratio of reserve to deposits, varying from twelve and a half 
per cent to twenty-five per cent, according as they are state 
or national banks, and according to their location. These 
reserves are all in defense of deposits. In defense of notes, 
on the other hand, no cash reserve is required — that is, of 
national banks. True, the same economic principles apply 
to both bank notes and deposits, but the law treats them 
differently. The government itself chooses to undertake to 
redeem the national bank notes on demand, imposing on the 
banks certain obligations to deposit with itself a redemption 
fund and government bonds. 

§ 4. The Total Currency and its Circulation 

The study of banking operations, then, discloses two 
species of bank currency : one, bank notes, belonging to the 
category of money ; and the other, deposits, belonging out- 
side of that category but constituting an excellent substi- 
tute. Referring these to the larger category of goods, we 
have a threefold classification of goods : first, money; second, 
deposit currency, or simply deposits; and third, all other 
goods. And by the use of these, there are six possible types 
of exchange : — 

(1) Money against money, 

(2) Deposits against deposits, 

(3) Goods against goods, 

(4) Money against deposits, 

(5) Money against goods, 

(6) Deposits against goods. 



1 66 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

For our purpose, only the last two types of exchange are 
important, for these constitute the circulation of currency. 
As regards the other four, the first and third have been pre- 
viously explained as " money changing " and " barter," 
respectively. The second and fourth are banking trans- 
actions : the second being such operations as the selling of 
drafts for checks or the mutual cancellation of bank clear- 
ings ; and the fourth being such operations as the depositing 
or withdrawing of money, by depositing cash or cashing 
checks. 

The analysis of the balance sheets of banks has prepared 
us for the inclusion of bank deposits or circulating credit in 
the equation of exchange. We shall still use M to express 
the quantity of actual money, and V to express the velocity 
of its circulation. Similarly, we shall now use M.' to express 
the total deposits subject to transfer by check ; and V' to 
express the average velocity of their circulation. The total 
value of purchases in a year is therefore no longer to be 
measured by MV, but by M V + M'V'. The equation of 
exchange, therefore, becomes 

MV + M'V'^^pQ = PT 

Let us again represent the equation of exchange by means 
of a mechanical picture. In Figure n, trade, as before, is 
represented on the right by the weight of a miscellaneous 



. ^■Mjm.jmip ... x . ...... ,. A ,,.,T,,,M,,,, JL .., IJ|| ,,,.^,i,. i i | .,, T ,,n..^ j|| l || l M,|.i., i M. rrir , IJ ,„,|,, T 




Fig. ii. 



assortment of goods ; and their average price by the distance 
to the right from the fulcrum, or the leverage at which 
this weight hangs. Again at the left, money (M) is repre- 
sented by a weight in the form of a purse, and its velocity of 



Sec. 5] DEPOSIT CURRENCY 1 67 

circulation ( V) by its leverage ; but now we have a new 
weight at the left, in the form of a bank book, to represent 
the bank deposits {M'). The velocity of circulation {V') 
of these bank deposits is represented by its distance from 
the fulcrum or the leverage at which the book hangs. 

This mechanism makes clear the fact that the average 
price (right leverage) increases with the increase of money or 
bank deposits and with the velocities of their circulation, 
and decreases with the increase in the volume of trade. 

Recurring to the left side of the equation of exchange, 
or MV + M'V, we see that in a community without bank 
deposits the left side of the equation reduces simply to 
MV, the formula of Chapter VIII ; for in such a community 
the term M ' V' vanishes. The introduction of M' tends to 
raise prices ; that is, the hanging of the bank book on the 
left requires a lengthening of the leverage at the right. 

§ 5. Deposit Currency Normally Proportional to Money 

With the extension of the equation of monetary circula- 
tion to include deposit circulation, the influence exerted by 
the quantity of money on general prices becomes less direct ; 
and the process of tracing this influence becomes more diffi- 
cult and complicated. It has even been argued that this 
interposition of circulating credit breaks whatever connec- 
tion there may be between prices and the quantity of money. 
This would be true if circulating credit were independent of 
money. But the fact is that the quantity of circulating 
credit, M' , tends to hold a definite relation to M, the quan- 
tity of money in circulation ; that is, deposits are normally 
a more or less definite multiple of money. 

Two facts normally give deposits a more or less definite 
ratio to money. The first has been already explained, viz., 
that bank reserves are kept in a more or less definite ratio 
to bank deposits. The second is that individuals, firms, 
and corporations preserve more or less definite ratios between 



1 68 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

their cash transactions and their check transactions, and also 
between their money and deposit balances. These ratios 
are determined by motives of individual convenience and 
habit. In general, business firms use money for wage pay- 
ments, and for small miscellaneous transactions included 
under the term " petty cash " ; while for settlements with 
each other they usually prefer checks. These preferences 
are so strong that we could not imagine them overridden 
except temporarily, and to a small degree. A business firm 
would hardly pay car fares with checks and liquidate its 
large liabilities with cash. Each person strikes an equilib- 
rium between his use of the two methods of payment, and 
does not greatly disturb it except for short periods of time. 
He keeps his stock of money or his bank balance in constant 
adjustment to the payments he makes in money or by check. 
Whenever his stock of money becomes relatively small and 
his bank balance relatively large, he cashes a check. In 
the opposite event, he deposits cash. In this way he is 
constantly converting one of the two media of exchange into 
the other. A private individual usually feeds his purse from 
his bank account ; a retail commercial firm usually feeds its 
bank account from its till. The bank acts as intermediary 
for both. 

For any one individual the adjustment of cash-in- 
pocket to deposits-in-bank will be extremely rough ; for 
sometimes the one or the other will be much too large or 
too small. But, for the community as a whole, the ad- 
justment of the cash to deposits used will be very deli- 
cate; for the temporary aberrations of many thousands 
of individuals will almost completely neutralize each other. 

In a given community the quantitative relation of deposit 
currency to money is determined by several considerations 
of convenience. In the first place, the more highly devel- 
oped the business of a community, the more prevalent the 
use of checks. Where business is conducted on a large scale, 
merchants habitually transact their larger operations with 



Sec. 6] DEPOSIT CURRENCY 1 69 

each other by means of checks, and their smaller ones by 
means of cash. Again, the more concentrated the popula- 
tion, the more prevalent the use of checks. In cities it is 
more convenient both for the payer and the payee to make 
large payments by check ; whereas, in the country, trips to 
a bank are too expensive in time and effort to be conven- 
ient, and therefore more money is used in proportion to the 
amount of business done. Again, the wealthier the members 
of the community, the more largely will they use checks. 
Laborers seldom use them ; but capitalists, professional and 
salaried men, use them habitually, for personal as well as 
business transactions. 

There is, then, a relation of convenience and custom be- 
tween check and cash circulation, and a more or less stable 
ratio between the deposit balance of the average man or 
corporation and the stock of money kept in pocket or till. 
This fact, as applied to the country as a whole, means that 
by convenience a fairly definite ratio is fixed between M 
and M' . If that ratio is disturbed temporarily, there will 
come into play a tendency to restore it. Individuals will 
deposit surplus cash, or they will cash surplus deposits. 

Hence, both money in circulation (as shown above) and 
money in reserve (as shown previously) tend to keep in a 
fixed ratio to deposits. It follows that the two must be in a 
more or less definite, though elastic, ratio to each other. 

§ 6. Summary 

The contents of this chapter may be formulated in a few 
simple propositions : — 

(1) Banks supply two kinds of currency, viz., bank notes 

— which are money ; and bank deposits (or rights to draw) 

— which are not money. 

(2) A bank check is merely an evidence of a right to 
draw. 

(3) Behind the claims of depositors and note holders 



170 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

stand, not simply the cash reserve, but all the assets of the 
bank. 

(4) Deposit banking is a device by which wealth, inca- 
pable of direct circulation, may be made the basis of the cir- 
culation of rights to draw. 

(5) The basis of such circulating rights to draw or de- 
posits must consist in part of actual money, and it should 
consist in part also of quick assets readily exchangeable for 
money. 

(6) Six sorts of exchange exist among the three classes of 
goods : money, deposits, and other goods. Of these six 
sorts of exchange, the most important for our present pur- 
poses are the exchanges of money and deposits against other 
goods. 

(7) The equation of money circulation, extended so as to 
make it include bank deposits, reads thus: MV + M'V 
= ^pQ = PT. 

(8) Bank deposits (M' ) tend to keep a normal ratio to 
bank reserves and to the quantity of money (M) ; because, 
in the first place, cash reserves are necessary to support 
bank deposits, and these reserves must bear some more or 
less constant ratio to the amount of such deposits ; and 
because, in the second place, business convenience dictates 
that the available currency shall be apportioned between 
deposits and money in a certain more or less definite, even 
though elastic, ratio. 



CHAPTER X 

THE EQUATION OF EXCHANGE DURING TRANSITION PERIODS 

§ i. The Tardiness of Interest Adjustment to Price 
Movements 

In the preceding chapter it was shown that the quantity 
of bank deposits normally maintains a more or less definite 
ratio to the quantity of money in circulation and to the 
amount of bank reserves. As long as this normal relation 
holds, the existence of bank deposits merely magnifies the 
effect on the level of prices produced by the quantity of 
money in circulation and does not in the least distort that 
effect. Moreover, changes in velocity or trade will have the 
same kind of effect on prices, whether bank deposits are 
included or not. 

But during periods of transition this relation between 
money (M) and deposits {M') is by no means rigid. By 
a period of transition is meant the interval of time during 
which a disturbance in any of the six magnitudes in the 
equation of exchange (for instance, an increase in the quantity 
of money in circulation) works out its effects. It takes time 
for any such disturbance to completely work out its effects, 
just as it takes time after a locomotive engineer has put 
on more steam for the full effects to be felt by the train 
which is drawn. There is always a transition period which 
must elapse before any new cause completes its full effects, 
and, during this transition period, the effects are somewhat 

171 



172 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. X 

different from the final effects after the transition period is 
over. Thus, if the final effect of suddenly putting on the 
increased steam will be to increase the speed of the train 
from thirty miles per hour to forty miles per hour, this effect 
will not be felt immediately. There will be a transition 
period of several minutes before this speed is attained. Dur- 
ing this transition period the speed will gradually increase, 
the couplings will expand and then contract, the passengers 
will feel jolted, and so forth. After the transition period 
is over, the train will run smoothly again. 

We are now ready to study periods of transition for the 
equation of exchange. The change which constitutes a 
transition may be a change in the quantity of money, or in 
any other factor of the equation of exchange, or in all. 
Usually all are involved, but the chief factor which we shall 
select for study (together with its effects on the other factors) 
is the quantity of money. If the quantity of money were 
suddenly doubled, the effect of the change would not be the 
same at first as later. The ultimate effect is, as we have 
seen, to double prices ; but before this happens, the prices 
oscillate up and down. In this chapter we shall consider 
the temporary effects during the period of transition separately 
from the permanent or ultimate effects which were considered 
in the last chapter. These permanent or ultimate effects 
follow after a new equilibrium is established — if, indeed, 
such a condition as equilibrium may be said ever to be 
established. What we are concerned with in this chapter 
are the temporary effects, i.e., those in the transition period. 

The transition periods may be characterized either by 
rising prices or by falling prices. Rising prices must be 
clearly distinguished from high prices, and falling from low. 
With stationary levels, high or low, we have in this chapter 
nothing to do. Our concern is with rising or falling prices. 
Rising prices mark the transition between a lower and a 
higher level of prices, just as a hill marks the transition be- 
tween flat lowlands and flat highlands. The study of these 



Sec. 2] THE EQUATION DURING TRANSITION PERIODS 1 73 

acclivities and declivities is bound up with the phenomena 
of business loans. 

It must be borne in mind that although business loans are 
made in the form of money, yet whenever a man borrows 
money he does not do this in order to hoard the money, 
but to purchase goods with it. Suppose A borrows $100 
from B. What has really been borrowed is purchasing 
power. If at the end of a year A returns $100 to B, but 
prices have meanwhile advanced, then B has lost a fraction 
of the purchasing power originally loaned to A. For even 
though A should happen to return to B the identical coins 
in which the loan was made, these coins represent somewhat 
less than the original quantity of purchasable commodities. 
Bearing this in mind, let us suppose that prices are rising. 
It is plain that the man who lends $100 at the beginning 
of the year will, when he receives back $100, say at the end 
of the year, not receive back as much purchasing power as 
he gave. In other words, he loses by the rise of prices. He 
could, it is true, safeguard himself against this loss if he 
could make sufficiently hard terms with the borrower ; 
but usually when prices are about to rise, neither the lender 
nor the borrower fully realizes that they are going to rise as 
much as they actually do. 

§ 2. How a Rise of Prices Generates a Further Rise 

We are now ready to study temporary or transitional 
changes in the factors of our equation of exchange. Let us 
begin by assuming a slight initial disturbance, such as would 
be produced, for instance, by an increase in the quantity 
of gold. This, through the equation of exchange, will cause 
a rise in prices. As prices rise, profits of business men 
measured in money will rise also, even if the costs of business 
were to rise in the same proportion. Thus, if a man who 
sold goods for $10,000 which cost $6000, clearing $4000, 
could get double prices at double cost, his profit would 



174 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. X 

double also, being $20,000 — $12,000, which is $8000. Of 
course, such a rise of profits would be purely nominal, as it 
would merely keep pace with the rise in price level. The 
business man would gain no advantage, for his larger money 
profits would buy no more than his former smaller money 
profits bought before. But, as a matter of fact, the busi- 
ness man's profits will usually rise more than this, because 
many of his expenses will tend to remain the same. In 
particular his payments to creditors for past loans and his 
payments to employees for work will for a time remain 
unaffected or little affected by the general rise in prices. 
Consequently, he will find himself making greater profits 
than usual, and be encouraged to expand his business by 
increasing his borrowings. These borrowings are mostly 
in the form of short-time loans from banks ; and, as we have 
seen, short-time loans engender deposits. Therefore, de- 
posit currency (M') will increase. But this extension of de- 
posit currency tends further to raise the general level of 
prices, just as the increase of gold raised it in the first place. 
This further rise of prices enables borrowers who are now 
receiving greater profits to receive still greater profits. 
Borrowing, already stimulated, is stimulated still further. 
More loans are demanded, and, with the resulting expansion 
of bank loans, deposit currency (W), already expanded, 
expands still more. Hence prices rise still further. 

This sequence of events may be briefly stated as 
follows : — ■ 

(1) Prices rise (whatever the first cause may be ; we have 
chosen for illustration an increase in the amount of money 
in circulation). 

(2) "Enterprisers," i.e., persons who undertake business 
enterprises of various kinds, get much higher prices than 
before, without having much greater expenses, and therefore 
make much greater profits. 

(3) Enterpriser-borrowers, encouraged by large profits, 
expand their loans. 



Sec. 3] THE EQUATION DURING TRANSITION PERIODS 1 75 

(4) Deposit currency {M') expands relatively to money 
(M). 

(5) Prices continue to rise, that is, phenomenon No. 1 is 
repeated. Then No. 2 is repeated, and so on. 

In other words, a slight initial rise of prices sets in motion 
a train of events which tends to repeat itself. Rise of prices 
generates rise of prices, and continues to do so as long as the 
enterprisers' profits continue abnormally high. 

§ 3. How a Rise of Prices Culminates in a Crisis 

The expansion in deposit currency indicated in this cu- 
mulative movement abnormally increases the ratio of M* 
to M. This, however, is not the only disturbance caused 
by the increase in M. There are disturbances to some ex- 
tent in the Q's, in V, and in V'. These will be taken up in 
order. In particular, trade (the Q's) will be stimulated by 
the stimulation of loans. New constructions of buildings, 
etc., are entered upon. These effects are always observed 
during rising prices, and people note approvingly that " busi- 
ness is good " and " times are booming." Such statements 
represent the point of view of the ordinary business man 
who is an " enterpriser-borrower." They do not represent 
the sentiments of the creditor, the salaried man, or the 
laborer, most of whom are silent but long-suffering, paying 
higher prices, but not getting proportionally higher incomes. 

Evidently the expansion cannot proceed forever. It 
must ultimately spend itself. The check upon its continued 
operation lies in making loans harder to get. As soon as this 
occurs, the whole situation is changed. The banks are 
forced in self-defense to refuse loans (or at any rate to dis- 
courage loans by making harder terms for them) because 
they cannot stand so abnormal an expansion of loans rela- 
tively to reserves. Then borrowers can no longer hope 
to make great profits, and loans cease to expand. 

There are other forces placing a limitation on further ex- 



176 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. X 

pansion of deposit currency and introducing a tendency to con- 
traction, but those above mentioned are the most important. 
With the rise of interest, those persons who have counted 
on renewing their loans on the former terms and for the 
former amounts are unable to do so. It follows that some 
of them are destined to fail. The failure (or prospect of 
failure) of firms that have borrowed heavily from banks in- 
duces fear on the part of many depositors that the banks will 
not be able to realize on these loans. Hence the banks them- 
selves fall under suspicion, and for this reason depositors 
demand cash. Then occur " runs on the banks," which 
deplete the bank reserves at the very moment they are most 
needed to pay the demands of the depositors. Being short 
of reserves, the banks have to curtail their loans. An enter- 
prise, as it is started by borrowing, is expected to be con- 
tinued by renewed borrowing. Renewed borrowing be- 
comes difficult or impossible, and even the original loans may 
be " called " by the banks. Those enterprisers who are 
caught must have currency to liquidate their obligations. 
Some of them are destined to become bankrupt, and, with 
their failure, the demand for loans is correspondingly re- 
duced. This culmination of an upward price movement is 
what is called a crisis, a condition characterized by failures 
which are due to a lack of cash when it is most needed. 
Bankruptcies, as shown in Chapter III, § 5, tend to spread 
from debtor to creditor. 

§ 4. Completion of the Credit Cycle 

The contraction of loans and deposits is accompanied by 
a decrease in velocities, and these conspire to prevent a 
further rise of prices and tend toward a fall. The crest of 
the wave is reached and a reaction sets in. Bank loans tend 
to be small, and consequently deposits (Af') are reduced. 
The contraction of deposit currency makes prices fall still 
more. Those who have borrowed for the purpose of buying 



Sec. 4l THE EQUATION DURING TRANSITION PERIODS 1 77 

stocks of goods, now find they cannot sell them for enough 
even to pay back what they have borrowed. The sequence 
of events is now the opposite of what it was before : — 

(1) Prices fall. 

(2) Enterprisers get much lower prices than before with- 
out having much lower expenses, and therefore make much 
lower profits. 

(3) Enterpriser-borrowers, discouraged by small profits, 
contract their borrowings. 

(4) Deposit currency (M') contracts relatively to money 

(Ji). 

(5) Prices continue to fall ; that is, phenomenon No. 1 is 
repeated. Then No. 2 is repeated, and so on. 

Thus a fall of prices generates a further fall of prices. 
The cycle evidently repeats itself as long as the enterprisers' 
profits remain abnormally low. The man who loses most 
is the business man in debt. He is the typical business man, 
and he now complains that " business is bad." There is a 
" depression of trade." 

The contraction becomes self-limiting as soon as loans are 
easier to get. Banks are led to make loans easy in order to 
get rid of their accumulated reserves. After a time, normal 
conditions begin to return. The weakest producers have 
been forced out, or have at least been prevented from ex- 
panding their business by increased loans. The strongest 
firms are left to build up a new credit structure. Borrowers 
again become willing to take ventures ; failures decrease in 
number ; bank loans cease to decrease ; prices cease to fall ; 
borrowing and carrying on business becomes profitable ; loans 
are again demanded ; prices again begin to rise, and there 
occurs a repetition of the upward movement already described. 

The upward and downward movements taken together 
constitute a complete credit cycle, which resembles the for- 
ward and backward movements of a pendulum. 

Many historical examples could be cited. The discovery 
of gold in California in the middle of the last century was 



178 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. X 

followed by an inflation of the world's currency, first through 
the new gold and later through expansion of deposit currency 
as well. Prices rose rapidly ; business men made high prof- 
its ; times were good until 1857, when a crisis occurred both 
in the United States and Europe. This was followed by 
a sharp fall in prices, a depression in trade, a recovery and 
another period of inflation culminating in a second crisis in 
1866. Again the pendulum swung back, only to return 
again in the crisis of 1873. A more recent example is found 
in the gold inflation beginning in 1896 in consequence of the 
enormous gold production in the Transvaal, in Cripple Creek, 
and in the Klondike. The money in circulation in the 
United States doubled in eleven years (1896-1907), bank 
deposits subject to check nearly trebled, prices rose 50 per 
cent. Prosperity seemed boundless. In 1907 the wave 
broke in the crisis of that year, followed by a contraction 
of deposits and a fall of prices in the next year with a gradual 
recovery in the years immediately following. 

We have considered the rise, culmination, fall, and re- 
covery of prices. In most cases the time occupied by the 
swing of the commercial pendulum to and fro is about ten 
years. While the pendulum is continually seeking a stable 
position, practically there is almost always some occurrence 
to prevent perfect equilibrium. Oscillations are set up which, 
though tending to be self-corrective, are continually per- 
petuated by fresh disturbances. 

The factors in the equation of exchange are continually 
seeking normal adjustment. A ship in a calm sea will 
" pitch " only a few times before coming to rest. But in a 
high sea the pitching never ceases. While continually 
seeking equilibrium, the ship continually encounters causes 
which accentuate the oscillation. 

The foregoing sketch of prices gives, of course, only the 
elementary features of price cycles. In any actual case 
numerous special factors enter. The factors which we have 
studied are those in the equation of exchange. 



CHAPTER XI 

INFLUENCES OUTSIDE THE EQUATION 

§ i. Influences which Conditions of Production and Con- 
sumption Exert on Trade and therefore on Prices 

Thus far we have considered the level of prices as affected 
by the volume of trade, by the velocity of circulation of 
money and of deposits, and by the quantity of money and 
of deposits. These are the only influences which can directly 
affect the level of prices. Any other influences on prices 
must act through these five. There are myriads of such 
influences (outside of the equation of exchange) that af- 
fect prices through the medium of these five. It is our 
purpose in this chapter to note the chief among them, 
excepting those that affect the volume of money (M) ; 
the latter will be examined in the next chapter. 

We shall first consider the outside influences that affect 
the volume of trade and, through it, the price level. The 
conditions which determine the extent of trade are numerous 
and technical. The most important may be classified as 
follows : — 

i. Conditions affecting producers. 

(a) Geographical differences in natural resources. 

(b) The division of labor. 

(c) Knowledge of the technique of production. 

(d) The accumulation of capital. 
2. Conditions affecting consumers. 

(a) The extent and variety of human wants. 
179 



l8o ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

3. Conditions connecting producers and consumers. 

(a) Facilities for transportation. 

(b) Relative freedom of trade. 

(c) Character of monetary and banking systems. 

(d) Business confidence. 

1. (a) It is evident that if all localities were exactly 
alike in their natural resources or, in other words, in 
their comparative costs of production, no trade would be 
set up between them. Primitive trade had its raison 
d'etre in the fact that the regions of this earth are unlike 
in their products. The traders were travelers between 
distant countries. Changes in commercial geography still 
produce changes in the distribution and volume of trade. 
The exhaustion of the gold and silver mines in California 
and in Nevada and of lumber in Michigan have tended to 
reduce the volume of trade of these regions, both external 
and internal. Contrariwise, cattle raising in Texas, the 
production of coal in Pennsylvania, of oranges in Florida, 
and of apples in Oregon, have increased the volume of 
trade for these communities, respectively. 

1. (b) Equally obvious is the influence of the division 
of labor. Division of labor is based in part on differences 
in comparative costs or efforts of different men producing 
different goods — corresponding to geographic differences as 
between countries. Because of such differences, natural 
and acquired, some men devote themselves to farming, 
others to weaving, others to carpentry, others to mason 
work, plumbing, typesetting, moving pianos, or driving 
aeroplanes. 

1. (c) Besides local and personal differentiation, the 
state of knowledge of the means and methods of production 
will stimulate trade. The mines of Africa and Australia 
were left unworked for centuries by ignorant natives, but 
were opened by white men possessing a knowledge of met- 
allurgy. Vast coal fields in China await development, 



Sec. i] INFLUENCES OUTSIDE THE EQUATION l8l 

largely for lack of knowledge of how to extract and market 
the coal. Egypt awaits the advent of scientific agricul- 
ture to usher in trade expansion. In several countries, 
particularly in Germany, England, and the United States, 
trade schools are increasing and diffusing knowledge of 
productive technique. 

i. (d) But knowledge, to be of use, must be applied; 
and its application usually requires the aid of capital. The 
greater and the more productive the stock of capital 
in any community, the more goods it can put into 
the currents of trade. A mill will make a town a center 
of trade. Docks, elevators, warehouses, and railway 
terminals help to transform a harbor into a port of 
commerce. 

Since increase in trade tends to decrease the general level 
of prices, it is obvious that anything which tends to 
increase trade likewise tends to decrease the general level 
of prices. We conclude, therefore, that among the 
various causes which tend to decrease prices are in- 
creasing geographical or personal specialization, im- 
proved productive technique, and the accumulation of 
capital. 

2. (a) Turning to the consumers' side, it is evident that 
their wants change from time to time. This is true even 
of so-called natural wants, but more conspicuously true of 
acquired or artificial wants. 

Wants are, as it were, the mainsprings of economic 
activity which in the last analysis keep the economic world 
in motion. The desire to have clothes as fine as the clothes 
of others, or finer, or different, leads to the multiplicity of 
silks, satins, laces, etc. ; and the same principle applies to 
furniture, amusements, books, works of art, and every 
other means of gratification. 

The increase of wants, in so far as it leads to an increase 
in trade, tends to that extent to lower the price level. 



1 82 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XI 

§ 2. Influence which Conditions Connecting Producers 
and Consumers Exert on Trade and therefore on 
Prices 

3. (a) Anything which facilitates intercourse tends to 
increase trade. Anything that interferes with intercourse 
tends to decrease trade. First of all there are the mechanical 
facilities for transport. As Macaulay said, with the ex- 
ception of the alphabet and the printing press, no set of 
inventions has tended to alter civilization so much as those 
which abridge distance — such as the railway, the steam- 
ship, the telephone, the telegraph, and that conveyer of 
information and advertisements, the newspaper. These 
all tend, therefore, to decrease prices. 

3. (b) Trade barriers are not only physical, but legal. 
A tariff between countries has the same influence in de- 
creasing trade as a chain of mountains. The freer the trade, 
the more of it there will be. In France, many communities 
have a local tariff (octroi) which tends to interfere with 
local trade. In the United States, trade is free within the 
country itself, but between the United States and other 
countries there is a high protective tariff. The very fact of 
increasing facilities for transportation, lowering or removing 
physical barriers, has stimulated nations and communities 
to erect legal barriers in their place. Tariffs not only tend 
to decrease the frequency of exchanges, but to the extent 
that they prevent international or interlocal division of 
labor and make countries more alike as well as less produc- 
tive, they also tend to decrease the amounts of goods 
which can be exchanged. The ultimate effect is thus to 
raise prices. 

3. (c) The development of efficient monetary and bank- 
ing systems tends, among other effects, to increase trade. 
There have been times in the history of the world when the 
money was in so uncertain a state that people hesitated 
to make many trade contracts because of the lack of knowl- 



Sec. 3] INFLUENCES OUTSIDE THE EQUATION 1 83 

edge of what would be required of them when the contract 
should be fulfilled. In the same way, when people cannot 
depend on the good faith or stability of banks, they will 
hesitate to use deposits and checks. 

3. (d) Confidence, not only in banks in particular, but 
in business dealings in general, is truly said to be " the 
soul of trade." Without this confidence there cannot be a 
great volume of contracts. Anything that tends to increase 
this confidence tends to increase trade. In South America 
there are many places waiting to be developed simply be- 
cause capitalists do not feel any security in contracts there. 
They are fearful that by hook or by crook the fruit of any 
investments they may make will be taken from them. 

We see, then, that prices will tend to fall through an 
increase in trade, which may in turn be brought about by 
improved transportation, by increased freedom of trade, 
by improved monetary and banking systems, and by busi- 
ness confidence. 

§ 3. Influence of Individual Habits on Velocities of 
Circulation, and therefore on Prices 

Having examined those causes outside the equation 
which affect the volume of trade, our next task is to consider 
those causes that affect the velocities of circulation of money 
and of deposits. For the most part, the causes affecting 
one of these velocities affect the other also. These causes 
may be classified as follows : — 

1 . Habits of the individual 

(a) As to hoarding, 

(b) As to book credit and loans, 

(c) As to the use of checks. 

2. Systems of payments in the community 

(a) As to frequency of receipts and of disbursements, 

(b) As to regularity of receipts and of disbursements, 



184 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

(c) As to correspondence between time and amount 
of receipts and of disbursements. 
3. General causes 

(a) Density of population, 

(b) Rapidity of transportation. 

1. (a) Taking these up in order, we may first consider 
what influence hoarding has on the velocity of circulation. 
Velocity of circulation of money is the same thing as its 
rate of turnover. It is found (Chapter VIII, § 3) by dividing 
the total payments effected by money in a year by the 
average amount of money in circulation in that year. It 
depends upon the rates of turnover of the individuals which 
compose the society. This velocity of circulation or rapidity 
of turnover of money is the greater for each individual, the 
more he expends with a given average amount of cash on 
hand, or the less average cash he keeps for a given yearly 
expenditure. One man keeps an average of $10 in his 
pocket and expends $500 a year ; he, therefore, turns over 
the contents of his pocket fifty times a year. Another, 
while expending the same sum ($500) , keeps the more prudent 
average of $20 ; he, therefore, turns over his stock of cash 
only twenty-five times a year. 

Some people are by habit always impecunious or short of 
ready money and tend to have a high rate of turnover; 
others carry a full purse and have a slow rate of turnover. 
When, as used to be the custom in France, people put money 
away in stockings and kept it there for months, the velocity 
of circulation must have been extremely slow. The same 
principle applies to deposits. 

Hoarded money is sometimes said to be withdrawn 
from circulation, but this is only another way of saying that 
hoarding tends to decrease the velocity of circulation. 

1. (b) The habit of " charging," i.e., using book credit, 
tends to increase the velocity of circulation of money, because 
the man who gets things "charged" does not need to keep 



Sec. 3] INFLUENCES OUTSIDE THE EQUATION 185 

on hand as much money as he would if he made all payments 
in cash. A man who daily pays cash needs to keep cash for 
daily contingencies. The system of cash payments, unlike 
the system of book credit, requires that money shall be kept 
on hand in advance of purchases. Evidently, if money 
must be provided in advance, it must be provided in larger 
quantities than when merely required to liquidate past 
debts. In the system of cash payments a man must keep 
money idle in advance, lest he be caught in the embarrassing 
position of lacking it when he most needs it. With book 
credit he knows that even if he should be caught without a 
cent in his pocket, he can still get supplies on credit. These 
he can pay for when money comes to hand. As soon as 
this money is received there is a use awaiting it to pay 
debts accumulated. For instance, a laborer receiving and 
spending $7 a week, if he cannot " charge," must make his 
week's wages last through the week. If he spends $1 a 
day, his weekly cycle must show on successive days at 
least as much as $7, $6, $5, $4, $3, $2, and $1, at which time 
another $7 comes in. This makes an average of at least 
$4. But if he can charge everything, and then wait until 
pay day to meet the resulting obligations, he need keep 
nothing through the week, paying out his $7 when it comes 
in. His weekly cycle need show no higher balances than 
$7, So, $0, $0, $0, $0, $0, the average of which is only Si. 

Analogous to book credit is the use of loans of any kind. 
In a highly organized center of trade, like the New York 
stock or produce exchanges, credit is extended to an extreme 
degree in order to facilitate the transactions of a large 
volume of business without the necessity of keeping on 
hand a large cash balance of money or deposits subject 
to check. Credit is extended by loans, by allowing pur- 
chases on small payments called " margins," and in other 
ways. All these extensions of loan credits tend to increase 
the velocity of circulation of money and deposits. 

Through book credit and loans, therefore, the average 



1 86 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

amount of money or bank deposits which each person must 
keep on hand to meet a given expenditure is made less. 
This means that the rate of turnover is increased; for if 
people spend the same amounts as before, but keep smaller 
amounts on hand, the quotient of the amount spent divided 
by the amount on hand must decrease. 

i. (c) The habit of using checks rather than money will 
also affect the velocity of circulation of money, because a 
depositor's surplus money will immediately be put in the 
bank in return for a right to draw by check. 

Banks thus offer an outlet for any surplus pocket money or 
surplus till money, and tend to prevent the existence of idle 
hoards. In like manner, surplus deposits may be converted 
into cash — that is, exchanged for cash — as desired. In 
short, those who make use both of cash and deposits have 
the opportunity, by adjusting the two, to prevent either 
from being idle. 

We see, then, that these three habits — the habit of 
being impecunious, the habit of charging, and the habit of 
using checks — all tend to raise the level of prices through 
their effects on the velocity of circulation of money, or of 
deposits. 

§ 4. Influence of Systems of Payments on Velocities 
of Circulation and therefore on Prices 

2. (a) The more frequently money or checks are received 
and disbursed, the shorter is the average interval between 
the receipt and the expenditure of money or checks, and 
the more rapid is the velocity of circulation. 

This may best be seen from an example. A change from 
monthly to weekly wage payments tends to increase the 
velocity of circulation of money. If a laborer is paid 
weekly $7, and reduces this evenly each day, ending each 
week empty-handed, his average cash, as we have seen, 
would be a little over half of $7, or about $4. This makes 



Sec. 4] INFLUENCES OUTSIDE THE EQUATION 1 87 

his turnover nearly twice a week. Under monthly pay- 
ments, the laborer who receives and spends an average 
of $1 a day will have to spread the $30, more or less evenly, 
over the following thirty days. If, at the next pay day, 
he comes out empty-handed, his average money during 
the month has been about $15. This makes his turnover 
about twice a month. Thus the rate of turnover is more 
rapid under weekly than under monthly payments. 

As a matter of history, however, it is not likely that the 
substitution of weekly payments for monthly payments has 
increased the rapidity of circulation of money among work- 
ingmen fourfold, because the change in another element, book 
credit, would be likely to cause a somewhat compensatory 
decrease. Book credit is less likely to be used under weekly 
than under monthly payments. Where this book-credit 
habit or habit of "charging" is prevalent, the great bulk of 
money is spent on pay day. It is probable that the substitu- 
tion of weekly for monthly payments, when it has taken 
place, has enabled many workingmen, who formerly found 
it necessary to trade on credit, to make their payments in 
cash, thus tending to decrease the rate of turnover of 
money. 

Frequency of disbursements evidently has an effect 
similar to the effect of frequency of receipts ; that is, it 
tends to accelerate the velocity of turnover, or circulation. 

2. (b) Regularity of payment also facilitates the turn- 
over. When the workingman can be fairly certain of both 
his receipts and expenditures, he can, by close calculation, 
adjust them so precisely as safely to end each payment 
cycle with an empty pocket. This habit is extremely 
common among certain classes of city laborers. On the 
other hand, if the receipts and expenditures are irregular, 
either in amount or in time, prudence requires the worker to 
keep a larger sum on hand to insure against mishaps. Even 
when foreknown with certainty, irregular receipts require 
a larger average sum to be kept on hand. We may, there- 



1 88 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

fore, conclude that regularity, both of receipts and of pay- 
ments, tends to increase velocity of circulation. 

2. (c) Next consider the synchronizing of receipts and 
disbursements, i.e., making payments at the same times 
as those at which receipts are obtained. It is manifestly 
a great convenience to the spender of money, or of deposits, 
if dealers to whom he is in debt will allow him to postpone 
payment until he has received his money or his check. This 
arrangement obviates the necessity of keeping much money 
or deposits on hand, and therefore increases their velocity 
of circulation. Where payments such as rent, interest, 
insurance, and taxes occur at periods irrespective of the 
times of receipts of money, it is often necessary to accumulate 
money or deposits in advance, thus increasing the average 
on hand, withdrawing money from use for a time, and de- 
creasing the velocity of circulation. 

We conclude, then, that synchronizing and regularity of 
payment, no less than frequency of payment, tend to in- 
crease prices by increasing velocity of circulation. 

§ 5. Influence of General Causes on Velocities of Circu- 
lation and therefore on Prices 

3. (a) The more densely populated a locality, the more 
rapid will be the velocity of circulation, because there will be 
readier access to people from whom money is received or to 
whom it is paid. In the country, although there are no 
statistics on this subject, the velocity of circulation must be 
much slower than in the city. A lady who has a city house 
and a country house states that in the country she keeps 
money in her purse for weeks, whereas in the city she keeps 
it but a few days. Pierre des Essars has worked out the 
velocity of circulation at banks in many European cities. 
Examination of his figures reveals the fact that, in almost 
all cases, the larger the town in which the bank is situated, 
the more active the deposits. The bank of Greece has a 



Sec. 6] INFLUENCES OUTSIDE THE EQUATION 1 89 

turnover whose rate of rapidity is only four times a year, 
while that of the bank of France is over one hundred times 
a year. 

3. (b) Again, the more extensive and the speedier the 
transportation in general, the more rapid the circulation 
of money. Anything which makes it easier to pass money 
from one person to another will tend to increase the velocity 
of circulation. Railways have this effect. The telegraph 
has increased the velocity of circulation of deposits, since 
these can now be transferred thousands of miles in a few 
minutes. Mail and express, by facilitating the transmission 
of bank deposits and money, have likewise tended to in- 
crease their velocity of circulation. 

We conclude, then, that density of population and rapidity 
of communication tend to increase prices by increasing 
velocities of circulation. 

§ 6. Influences on the Volume of Deposit Currency 
and therefore on Prices 

We have to consider lastly the specific outside influences 
on the volume of deposits subject to check. 
These are chiefly : — 

(1) The system of banking and the habits of the people 
in utilizing that system. 

(2) The habit of charging. 

(1) It goes without saying that a banking system must 
be devised and developed before deposits can affect prices 
or even exist. The invention of banking has undoubtedly 
led to a great increase in deposits and a consequent rise 
of prices. This has been true, in spite of the fact that, as 
pointed out in Section 1, the development of efficient 
monetary and banking systems tends to increase trade and 
to that extent to lower the price level. As in many other 
instances, the effects of improving monetary and banking 



I90 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

facilities are complex, affecting more than one factor in the 
equation of exchange. 

(2) We have already seen that " charging " increases 
the velocity of circulation of money. It is also a means of 
increasing the volume of deposits subject to check; that 
is, " charging " is often a preliminary to payment by check 
rather than by cash. If a customer did not have his obliga- 
tions " charged," he would pay in money and not by check. 
The ultimate effect of the practice of charging, therefore, is 
to increase the ratio of check payments to cash payments 
and the ratio of deposits to money carried {M f to M) and 
therefore to increase the amount of credit currency which 
a given quantity of money can sustain. 

This effect, the substitution of checks for cash payments, 
is probably by far the most important effect of " charging," 
and exerts a powerful influence toward raising prices. 



CHAPTER XII 

INFLUENCES OUTSIDE THE EQUATION 

(Continued) 

§ i. Influence of " The Balance of Trade " on the 
Quantity of Money and therefore on Prices 

We have now considered those influences outside the 
equation of exchange which affect the volume of trade (the 
Q's), the velocities of circulation of money and deposits (V 
and V'), and the amount of deposits {M'). We have re- 
served for separate treatment in this chapter the outside 
influences which affect the quantity of money (M). 

The chief of these may be classified as follows : — 

(i) Influences operating through the exportation and 
importation of money. 

(2) Influences operating through the melting or minting 
of money. 

(3) Influences operating through the production and 
consumption of money metals. 

(4) Influences of monetary and banking systems. 

The first to be considered is the influence of foreign 
trade on the quantity of money in a country and therefore 
on its price level. Hitherto we have confined our studies 
of price levels to an isolated community, having no trade 
relations with other communities. In the modern world, 
however, no such community exists, and it is important to 
observe that international trade gives present-day problems 
of money and of the price level an international character. 

191 



192 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XII 

If all countries had their own irredeemable paper money and 
no money that was acceptable elsewhere, price levels in 
different countries would have no intimate connection. 
Indeed, to some extent the connection is actually broken 
between existing countries which have different metallic 
standards — for example, between a gold-basis and a silver- 
basis country — although through their nonmonetary uses 
the two metals are still somewhat bound together. But 
where two or more nations trading with each other use 
the same standard, there is a tendency for the price levels 
of each to influence profoundly the price levels of the 
other. 

The price level in a small country like Switzerland de- 
pends largely upon the price level in other countries ; for if 
the price level in these other countries is higher or lower 
than in Switzerland, the difference will set up trade currents 
which will increase or decrease the quantity of money in 
Switzerland and therefore raise or lower its level of prices 
to correspond to the levels outside. Gold, which is the pri- 
mary or full-weight money in most civilized nations, is in 
this way constantly sent from one country or community to 
another. When a single small country is under considera- 
tion, while it is quite correct to say that the quantity of 
money in that country determines the price level, we must 
not fail to note that the quantity of money within its borders 
is in turn dependent upon the level of prices outside. An in- 
dividual country bears the same relation to the world that a 
lagoon bears to the ocean. The level of the lagoon depends, 
of course, upon the quantity of water in it. But the 
quantity of water in it depends in turn upon the level of the 
ocean. As the tide in the outside ocean rises and falls, the 
quantity of water in the lagoon will adjust itself accordingly. 

To simplify the problem of the distribution of money 
among different communities, we shall, for the time being, 
ignore the fact that money consists ordinarily of material 
capable of nonmonetary uses. We shall therefore omit 



Sec. i] OUTSIDE INFLUENCES 193 

consideration of the disappearance of money through 
melting ; likewise, for the present, we shall omit considera- 
tion of the production of money through minting. 

Let us, then, consider the causes that determine the 
quantity of money in a state like Connecticut. If the level 
of prices in Connecticut temporarily falls below that of 
the surrounding states, Rhode Island, Massachusetts, 
and New York, the effect is to cause an export of money 
from these states to Connecticut, because people will buy 
goods wherever they are cheapest and sell them wherever 
they are dearest. With its low prices, Connecticut becomes 
a good place to buy from, but a poor place to sell in. But 
if outsiders buy of Connecticut, they will have to bring 
money to buy with. There will, therefore, be a tendency 
for money to flow to Connecticut until the level of prices 
there rises to a level which will arrest the influx. If, on 
the other hand, prices in Connecticut are higher than in 
surrounding states, it becomes a good place to sell in and a 
poor one to buy from. But if outsiders sell in Connecticut, 
they will receive money in exchange. There is then a tend- 
ency for money to flow out of Connecticut until the level 
of prices in Connecticut is lower. In general, money flows 
away from places where the level of prices is high, and to- 
wards places where it is low. Men sell goods where they 
can get most money, and buy goods where they will have 
to give least money. We say " money," for in the long 
run we do not need to consider the interflow of bank de- 
posits; as we have seen, in the long run deposit currency 
in each country will maintain a definite ratio to money. 
In the long run an increase or decrease of money in a 
country will increase or decrease its deposits. 

But it must not be inferred that the prices of various 
articles or even the general level of prices will become 
precisely the same in different countries. Distance, igno- 
rance as to where the best markets are to be found, 
tariffs, and costs of transportation, help to maintain 



194 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XII 

price differences. The native products of each region 
tend to be cheaper in that region. They are exported as 
long as the excess of prices abroad is enough to more than 
cover the cost of transportation. Practically a commodity 
will not be exported at a price which will not at least be equal 
to the price in the country of origin, plus the freight. Many 
commodities are shipped only one way. Thus, wheat is 
shipped from the United States to England, but not from 
England to the United States. It tends to be cheaper in 
the United States. Large exportations raise its price in 
America toward the price in England, but the American 
price will usually remain below the English price by the 
cost of transportation. Other commodities may be sent 
in either direction, according to market conditions. 

But, although international or interlocal trade will never 
bring about exact uniformity of price levels, it will, to the 
extent that it exists, produce an adjustment of these levels 
toward uniformity by regulating, in the manner already 
described, the distribution of money. If one commodity 
enters to any considerable extent into international trade, 
it alone will suffice, though slowly, to act as a regulator 
of money distribution; for, in return for that commodity, 
money may flow, and, as the price level rises or falls, the 
quantity of that commodity sold is correspondingly adjusted. 
In ordinary intercourse between nations, even when a de- 
liberate attempt is made to interfere with it by protective 
tariffs, there will always be a large number of commodities 
thus acting as outlets and inlets. And since the quantity 
of money itself affects prices for all sorts of commodities, 
the regulative effect of international trade applies, not 
simply to the commodities which enter into that trade, 
but to all others as well. It follows that nowadays interna- 
tional or interlocal trade is constantly regulating price 
levels throughout the world. 

We must not leave this subject without emphasizing 
the effects of a tariff on the purchasing power of money. 



Sec. i] OUTSIDE INFLUENCES 1 95 

When a country adopts a duty on imports, the tendency is 
for the level of prices in that country to rise. A tariff 
obviously raises the prices of the " protected " goods. But 
it does more than that — it tends also to raise the prices of 
wwprotected goods. Thus, the tariff first causes a decrease in 
imports. Though in the long run this decrease in imports 
will lead to a corresponding decrease in exports, yet at 
first there will be no such adjustment. The foreigner 
will, for a time, continue to buy from the protected country 
almost as much as before. This will result temporarily 
in an excess of that country's exports over its imports, or 
a so-called " favorable " balance of trade, and a consequent 
inflow of money. This inflow will eventually raise the 
prices, not alone of protected goods, but of unprotected 
goods as well. The rise will continue till it reaches a point 
high enough to put a stop to the " favorable " balance of 
trade. 

Although the " favorable balance " of trade created by 
a tariff is temporary, it leaves behind a permanent in- 
crease of money and of prices. This is, perhaps, the chief 
reason why a protective tariff seems to many a cause of 
prosperity. It furnishes a temporary stimulus not only to 
protected industries, but to trade in general, which is in 
reality simply the stimulus of money inflation. The per- 
manent effect is to keep prices in general, including wages, 
at a higher level in the protected country than in free trade 
countries. This is doubtless one reason why American 
wages, prices, and cost of living are higher than English. 

We have shown how the international or interlocal 
equilibrium of prices may be disturbed by changes in the 
distribution of money alone. But it may also be disturbed 
by changes in the volume of bank deposits, or in the velocity 
of circulation of money, or in the velocity of circulation 
of bank deposits, or in the volume of trade. But whatever 
may be the source of the difference in price levels, equi- 
librium will eventually be restored through an international 



196 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

or interlocal redistribution of money and goods brought 
about by international and interlocal trade. Elements in 
the equation of exchange other than money and com- 
modities cannot be transported from one place to another. 

§ 2. Influence of Melting and Minting on the Quantity 
of Money and therefore on Prices 

We have seen how M in the equation of exchange is 
affected by the importation or exportation of money. 
Considered with reference to the M in any one of the 
countries concerned, the M's in all the others are " outside 
influences." 

Proceeding now one step farther, we must consider those 
influences on M that are not only outside of the equation 
of exchange for any particular country, but also outside 
that for the whole world. Besides the monetary inflow and 
outflow through importation and exportation, there is an 
inflow and outflow through minting and melting. In other 
words, not only do the stocks of money in the world connect 
with each other like interconnecting bodies of water, but they 
connect in the same way with the outside stock of bullion. 
In the modern world one of the precious metals, such as 
gold, usually plays the part of primary money, and this 
metal has two uses — a monetary use and a commodity use. 
That is to say, gold is not only a money material, but a com- 
modity as well. In their character of commodities, the 
precious metals are raw materials for jewelry, works of 
art, and other products into which they may be wrought. 
It is in this unmanufactured or raw state that they are 
called bullion. 

Gold money may be changed into gold bullion, and 
vice versa. In fact, both changes are going on constantly, 
for if the value of gold as compared with other commodities is 
greater in the one use than in the other, gold will immediately 
flow toward whichever use is more profitable, and the market 



Sec. 2] OUTSIDE INFLUENCES 1 97 

price of gold bullion in terms of gold money will determine 
the direction of the flow. Since 100 ounces of gold, -& fine, 
can be transformed into i860 gold dollars, the market value 
of so much gold bullion, ^o fine, must tend to be $1860. If 
it costs nothing to have bullion coined into money, and 
nothing to melt money into bullion, there will be an 
automatic flux and reflux from money to bullion and 
from bullion to money that will prevent the price of 
bullion from varying greatly. On the one hand, if the 
price of gold bullion is greater than the money which 
could be minted from it, for instance, if 100 ounces of gold 
sell for $1861, the users of gold who require bullion — 
notably jewelers — will save the $1 difference by melting 
$ i860 of gold coin into 100 ounces of bullion. Contrariwise, 
if the price of bullion is less than the value of gold coin, 
say $1859, the owners of bullion will save the Si difference 
by taking 100 ounces of bullion to the mint and having it 
coined into i860 gold dollars. The effect of melting coin, 
on the one hand, is to decrease the amount of gold money 
and increase the amount of gold bullion, thereby lowering 
the value of gold as bullion and raising the value of gold 
as money ; and thereby also lowering the price level and 
restoring the equality between bullion and money. The 
effect of minting bullion into coin is, by the opposite pro- 
cess, to bring the value of gold as coin and the value of 
gold as bullion into equilibrium. 

When a charge called " seigniorage " is made for changing 
bullion into coin, or where the process involves expense or 
delay, the flow of bullion into currency will be to that extent 
impeded. But under a modern system of free coinage and 
with modern methods of reducing coin to bullion, both 
melting and minting may be performed so inexpensively 
and so quickly that there is practically no cost or delay 
involved. In fact, there are few instances of more exact 
price adjustment than the adjustment between gold bullion 
and gold coin. It follows that the quantity of money, and 



198 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

therefore its purchasing power, is directly dependent on 
that of gold bullion. 

This stability of the price of gold bullion expressed in 
gold coin causes confusion in the minds of people, giving 
them the erroneous impression that there is no change 
in the value of money. Indeed, this stability has often 
been cited to show that gold is a stable standard of value. 
Dealers in objects made of gold seem to misunderstand 
the significance of the fact that an ounce of gold (t^ fine) 
always costs about $18.60 in the United States or £3, 
ijs., and io| d. in England. This means nothing more than 
the fact that gold in one form and measured in one way 
will always bear a constant ratio to gold in another form 
and measured in another way. An ounce of gold bullion 
is worth a fixed number of gold dollars, for the same reason 
that a pound sterling of gold is worth a fixed number of 
gold dollars, or that a ton of large steel ingots is worth a 
fixed number of pounds of small steel ingots. 

Except, then, for extremely slight and temporary fluctu- 
ations, gold bullion and gold money must always have the 
same value. Therefore, in the following discussion re- 
specting the more considerable fluctuations affecting both, 
we shall speak of these values interchangeably as " the 
value of gold." 

§ 3. Influence of the Production and Consumption of 

Money Metals on the Quantity of Money 

and therefore on Prices 

The stock of bullion is not the ultimate outside influence 
on the quantity of money. As the stock of bullion and the 
stock of money influence each other, so the total stock of 
both is itself influenced by production and consumption. 
The production of gold consists in the output of the mines, 
which constantly tends to add to the existing stocks both 
of bullion and coin. The consumption of gold consists 



Sec. 3] OUTSIDE INFLUENCES 1 99 

in the use of bullion in the arts by being wrought into 
jewelry, gilding, etc., and in losses by abrasion, shipwreck, 
etc. If we consider the amount of gold coin and bullion 
as contained in a reservoir, production would be the inflow 
from the mines, and consumption the outflow to the arts 
and by destruction and loss. To the inflow from the mines 
should be added the re-inflow from forms of art into which 
gold had previously been wrought, but which have grown 
obsolete. This is illustrated by the business of producing 
gold bullion by burning gold picture frames. 

We shall consider, first, the inflow or production, and 
afterward the outflow or consumption. The regulator 
of the inflow (which practically means the production of 
gold from the mines) is its estimated " marginal cost of 
production." Wherever the estimated cost of producing 
a dollar of gold is less than the existing value of a dollar in 
gold, it will normally be produced. Wherever the cost 
of production exceeds the existing value of a dollar, gold 
will normally not be produced. In the former case the 
production of gold is profitable ; in the latter it is unprofit- 
able. 

This holds true, in whatever way cost of production is 
measured, whether in terms of gold itself, or in terms of 
some other commodity such as wheat, or of commodities 
in general, or of any supposed " absolute " standard of value. 
In gold-standard countries gold miners do actually reckon 
the cost of producing gold in terms of gold. From their 
standpoint it is a needless complication to translate the 
cost of production and the value of the product into some 
other standard than gold. They are interested in the rela- 
tion between the two, and this relation will be the same 
whichever standard is employed. 

To illustrate how the producer of gold measures everything 
in terms of gold, suppose that the price level rises. He will 
then have to pay more dollars for wages, machinery, fuel, 
etc., while the prices obtained for his product (expressed in 



200 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

those same dollars) will, as always, remain unchanged. 
Conversely, a fall in the price level will lower his cost of 
production (measured in dollars), while the price of his 
product will still, as always, remain the same. Thus we 
have a constant number expressing the price of gold product 
and a variable number expressing its cost of production. 

If we express the same phenomena, not in terms of gold, 
but in terms of wheat, or rather, let us say, in terms of goods 
in general, we shall have the opposite conditions. 

Thus the comparison between price and cost of production 
is the same, whether we use gold or other commodities as our 
criterion. In the one view — i.e., when prices of labor and 
commodities are measured in gold — a rise of these prices 
appears as a rise in the gold miner's cost of production — 
the money cost to him of labor and materials — while the 
price of his product, gold, appears constant ; in the other 
view — i.e., when labor and commodities are measured in 
other goods — the same phenomenon is expressed as a fall 
in the purchasing power of his product, gold, while the cost 
of labor and materials in terms of themselves is the constant 
quantity. In the one view his costs rise relatively to his prod- 
uct; in the other his product falls relatively to his costs. 
In either view he will be discouraged. He will look at his 
troubles in the former light, i.e., as a rise in the cost of 
production ; but we shall find it more useful to look at them 
in the latter, i.e., as a fall in the purchasing power of the 
product. In either case the comparison is between the cost 
of the production of gold and the purchasing power of 
gold. If this purchasing power is above the cost of pro- 
duction in any particular mine, it will pay to work that 
mine. If the purchasing power of gold is lower than the 
cost of production in any particular mine, it will not pay 
to work that mine. Thus the production of gold increases 
or decreases with an increase or decrease in the purchasing 
power of gold. 

So much for the inflow of gold and the conditions regulat- 



Sec. 4] OUTSIDE INFLUENCES 201 

ing it. We turn next to outflow or consumption of gold. 
This has two forms, viz., consumption in the arts and con- 
sumption for monetary purposes. 

First we consider its consumption in the arts. If objects 
made of gold are cheap — that is, if the prices of other 
objects are relatively high — then the relative cheapness 
of the gold objects will lead to an increase in their use 
and consumption. Expressing the matter in terms of money 
prices, when prices of everything else are higher and people's 
incomes are likewise higher, while gold watches and gold 
ornaments generally remain at their old prices, people will 
use and consume more gold watches and ornaments. 

These are instances of the consumption of gold in the 
form of commodities. The consumption and loss of gold 
as coin is a matter of abrasion, of loss by shipwreck and other 
accidents. They change with the changes in the amount 
of gold in use and in its rapidity of exchange. 

Wesee, then, that the consumption of gold is stimulated by 
a fall in the price (purchasing power) of gold, while the pro- 
duction of gold is discouraged by a fall in its price. An in- 
crease of purchasing power, of course, acts in the opposite 
way. The purchasing power of money, being thus played 
upon by the opposing forces of production and consumption, 
is driven up or down as the case may be. 

§ 4. Mechanical Illustration of these Influences 

In any complete picture of the forces determining the 
purchasing power of money we need to keep prominently 
in view three groups of factors: (1) the production or the 
11 inflow" of gold (i.e., from the mines) ; (2) the consumption 
or " outflow " (into the arts and through destruction and 
loss) ; and (3) the " stock " or reservoir of gold (whether 
coin or bullion) which receives the inflow and suffers the 
outflow. The relations among these three sets of magni- 
tudes can be set forth by means of a mechanical illustration, 



202 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

given in Figure 12. This represents two connected reser- 
voirs of liquid, G b and G m . The contents of the first reser- 
voir represent the stock of gold bullion, and the contents 
of the second the stock of gold money. Since purchasing 
power increases with scarcity, the distance from the top of 
the cisterns, 00, to the surface of the liquid, is taken to 
represent the purchasing power of gold over other goods. 




'-■- "^ - — o 



Fig. 12. 



A lowering of the level of the liquid indicates an in- 
crease in the purchasing power of money, since we measure 
this purchasing power downward from the line 00 to the 
surface of the liquid. We shall not attempt to represent 
other forms of currency explicitly in the diagram. We have 
seen that normally the quantities of other currency are 
proportional to the quantity of primary money, which we 
are supposing to be gold. Therefore the variation in the 
purchasing power of this primary money may be taken as 
representative of the variation of all the currency. The 
cistern G m must be of such a form as will make the 
distance of the liquid surface below 00 decrease with an in- 
crease of the liquid, in exactly the same way as the purchasing 
power of gold decreases with an increase in its quantity. That 
is, as the quantity of liquid in G m doubles, the distance 



Sec. 4] OUTSIDE INFLUENCES 203 

of the surface from the line 00 should decrease by one half. 
In a similar manner the form of the gold bullion cistern 
must be such as will make it represent faithfully the facts 
for which it stands ; that is, it must be such that the dis- 
tance of the liquid surface below 00 will decrease with an 
increase of the liquid exactly as the value of the gold bullion 
decreases with an increase in the stock of gold bullion. The 
shapes of the two cisterns need not, and ordinarily will not, 
be the same, for we can scarcely suppose that doubling the 
amount of bullion in existence will always exactly halve its 
purchasing power. 

Both reservoirs have inlets and outlets.' Let us con- 
sider these in connection with the bullion reservoir (G b ). 
Here each inlet represents a particular mine supplying 
bullion, and each outlet represents a particular use in the 
arts consuming gold bullion. Each mine and each use has 
its own distance from 00. There are, however, three sets 
of distances from 00 : the inlet-distances, the outlet-dis- 
tances, and the liquid-surface-distances. Each inlet-distance 
represents the cost of production, measured in goods, for 
each mine ; each outlet-distance represents the value of gold 
in some particular use, likewise measured in goods. The 
surface-distance, as we have already explained, represents 
the value of bullion, likewise measured in goods — in 
other words, its purchasing power. 

It is evident that among these three sets of levels there 
will be discrepancies. These discrepancies serve to inter- 
pret the relative state of things as bullion flows in and out. 
If an inlet at a given moment be above the surface-level, i.e., 
at a less distance from 00 than is the surface, the interpre- 
tation is that the cost of production is less than the purchasing 
power of the bullion. Hence the mine owner will turn on 
his spigot and keep it on until, perchance, the surface-level 
rises to the level of his mine — i.e., until the surface-distance 
from 00 is as small as the inlet-distance — in other words, 
until the purchasing power of bullion is as small as the cost 



204 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

of production. At this point there is no longer any profit in 
mining. So much for inlets ; now let us consider the outlets. 
If an outlet at a given moment be below the surface-level, i.e., 
at a greater distance from 00, the interpretation is that the 
value of gold in that particular use is greater than the pur- 
chasing power of bullion. Hence gold bullion will flow into 
those uses where its worth is greater than as bullion. That 
is, it will flow out of all outlets below the surface in the 
reservoir. 

It is evident, therefore, that at. any given moment, only 
the inlets above the surface-level, and only the outlets 
below it, will be called into operation. As the surface 
rises, therefore, more outlets will be brought into use, but 
fewer inlets. That is to say, the less the purchasing power 
of gold as bullion, the more it will be used in the arts, but 
the less profitable it will be for the mines to produce it, 
and the smaller will be the output of the mines. As the 
surface falls, more inlets will come into use and fewer out- 
lets. 

We turn now to the money reservoir (G m ). The fact 
that gold has the same value either as bullion or as coin, 
because of the interflow between them is represented in the 
diagram by connecting the bullion and coin reservoirs, in 
consequence of which the stock in both will (like water) find 
a common level ; the surface of the liquid in both reservoirs 
will be the same distance below the line 00, and this distance 
represents the value of gold (or its purchasing power). 
Should the inflow at any time exceed the outflow, the result 
will necessarily be an increase in the stock of gold in exist- 
ence. This will tend to decrease the purchasing power 
or value of gold. But as soon as the surface rises, fewer in- 
lets and more outlets will operate. That is, the excessive in- 
flow on the one hand will decrease, and the deficient outflow 
or consumption on the other hand will increase, checking 
the inequality between the outflow and inflow. If, on the 
other hand, the outflow should temporarily be greater 



Sec. 4] OUTSIDE INFLUENCES 205 

than the inflow, the reservoir will tend to become less full. 
The purchasing power will increase; thus the excessive 
outflow will be checked, and the deficient inflow stimulated 
— restoring equilibrium. The exact point of equilibrium 
may seldom or never be realized, but as in the case of a 
pendulum swinging back and forth through a position of 
equilibrium, there will always be a tendency to seek it. 

It need scarcely be said that our mechanical diagram 
is intended merely to give a picture of some of the 
chief variables involved in the problem under discussion. 
It does not of itself constitute an argument, or add any new 
element ; nor should one pretend that it includes ex- 
plicitly all the factors which need to be considered. But it 
does enable us to grasp the chief factors involved in deter- 
mining the purchasing power of money. It enables us to 
observe and trace the following important variations and 
their effects : — 

First, if there be an increased production of gold — due, 
let us suppose, to the discovery of new mines or improved 
methods of working old ones — this may be represented 
by an increase in the number or size of the inlets into the 
bullion reservoir; the result will evidently be an increase 
of " inflow " into that reservoir, and from that into the 
currency reservoir, a consequent gradual filling up of both, 
and therefore a decrease in the purchasing power of money. 
This process will be checked finally by an increase in con- 
sumption and by discouraging production. When pro- 
duction and consumption become equal, an equilibrium will 
be established. An exhaustion of gold mines obviously 
operates in exactly the reverse manner. 

Secondly, if there be an increase in the consumption 
of gold — as through some change of fashion — it may be 
represented by an increase in the number or size of the out- 
lets of G b . The result will be a draining out of the bullion 
reservoir, and consequently a decreased amount in the 
currency reservoir ; hence an increase in the purchasing 



206 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

power of gold, which increase will be checked finally by an 
increase in the output of the mines as well as by a decrease 
in consumption. When the increased production and the 
decreased consumption become equal, equilibrium will 
again be reached. 

If the connection between the bullion reservoir and the 
currency reservoir is closed by a valve so that gold cannot 
flow from the former to the latter (although it can flow 
in the reverse direction), then the purchasing power of the 
gold as money may become greater than its value as bullion. 
Any increase in the production of gold will then tend only 
to fill the Jbullion reservoir and decrease the distance of the 
surface from the line 00, i.e., lower the value of gold bullion. 
The surface of the liquid in the money reservoir will not be 
brought nearer 00. It may even by gradual loss be lowered 
farther away. In other words, the purchasing power of 
money will by such a circumstance be made entirely inde- 
pendent of the value of the bullion out of which it was first 
made. 

We have now discussed all but one of the outside influences 
upon the equation of exchange. That one is the character 
of the monetary and banking system which affects the quan- 
tity of money and deposits. This we reserve for special 
discussion in the following two chapters. 

Meanwhile, it is noteworthy that almost all of the 
influences affecting either the quantity or the velocities 
of circulation have been and are predominantly in the 
direction of higher prices. Almost the only opposing 
influence is the increased volume of trade. We may 
also point out that some of those influences discussed 
in this and the preceding chapter operate in more than 
one way. Consider, for instance, technical knowledge 
and invention, which affect the equation of exchange 
by increasing trade. So far as these increase trade, the 
tendency is to decrease prices ; but so far as they develop 
metallurgy and the other arts which increase the production 



Sec. 4] OUTSIDE INFLUENCES 207 

and transportation of the precious metals, they tend to in- 
crease prices. So far as they make the transportation and 
transfer of money and deposits quicker, they also tend to 
increase prices. So far as they lead to the development of 
the art of banking, they likewise tend to increase prices 
both by increasing deposit currency {M') and by increasing 
the velocity of circulation both of money and deposits. 
So far as they lead to the concentration of population in 
cities, they tend to increase prices by accelerating circulation. 



CHAPTER XIII 

OPERATION OF MONETARY SYSTEMS 

§ i. Gresham's Law 

Thus far we have considered the influences that determine 
the purchasing power of money when the money in cir- 
culation is all of one kind. The illustration given in the 
previous chapter shows how the money mechanism operates 
when a single metal is used. We have now to consider the 
monetary systems in which more than one kind of money 
is used. 

One of the first difficulties in the early history of money 
was that of keeping two (or more) metals in circulation. 
One of the two would become cheaper than the other, and 
the cheaper would drive out the dearer. 

To this tendency has been given the name of " Gresham's 
Law " in honor of Sir Thomas Gresham, a financial adviser 
of Queen Elizabeth of England. It was he who pro- 
pounded it in the middle of the sixteenth century, although 
it is now known that many others had anticipated him. 
In fact, the law seems to have been recognized among the 
ancient Greeks. It is mentioned in the " Frogs " of Aris- 
tophanes : — 

" For your old and standard pieces, valued and approved and tried, 
Here among the Grecian nations and in all the world beside 
Recognized in every realm for trusty stamp and pure assay, 
Are rejected and abandoned for the trash of yesterday ; 
For a vile, adulterate issue, drossy, counterfeit and base 
Which the traffic of the City passes current in their place ! " 

208 



SEC. i] OPERATION OF MONETARY SYSTEMS 200, 

Gresham's Law is ordinarily stated in the form, " Bad 
money drives out good money," for it was usually ob- 
served that the badly worn, defaced, light-weight, " clipped," 
" sweated," and otherwise deteriorated money tended to 
drive out the full-weight, freshly minted coins. This for- 
mulation, however, is not accurate. " Bad " coins, e.g., 
worn, bent, defaced, or even clipped coins, will drive out 
other money only so far as they are less valuable. Ac- 
curately stated, the Law is simply this : Cheap money will 
tend to drive out dear money. The reason why the cheaper 
of two moneys always prevails is that the choice of the use 
of money rests chiefly with the man who gives it in ex- 
change, not with the man who receives it. When any one 
has the choice of paying his debts in either of two moneys, 
motives of economy will prompt him to use the cheaper. If 
the initiative and choice lay principally with the person 
who receives instead of the person who pays the money, 
the opposite would hold true. The dearer or " good " 
money would then drive out the cheaper or " bad " 
money. It is because the payer of money exercises the 
choice that the cheaper money tends to continue in circu- 
lation. Those who are most instrumental in withdrawing 
the good money from circulation are those who wish it for 
export or for melting, as, for instance, the goldsmiths. 

What then becomes of the dearer money? It may be 
hoarded, or go into the melting pot, or go abroad — hoarded 
and melted from motives of economy, and sent abroad be- 
cause, where foreign trade is involved, it is the foreigner 
who receives the money, rather than ourselves who give it, 
who dictates what kind of money shall be accepted. He 
will take only the best, because our legal-tender laws do 
not bind him. 

Gresham's Law applies not only to two rival moneys of 
the same metal ; it applies to all moneys that circulate con- 
currently. Until " milling " the edges of coins was in- 
vented, and a " limit of tolerance " of the mint (deviation 



2IO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

from the standard weight) was adopted, much embarrass- 
ment was felt in commerce from the fact that the clipping 
and debasing of coin was a common practice. Nowadays, 
however, any coin which has been so " sweated " or 
clipped as to reduce its weight appreciably ceases to be 
legal tender, and, being commonly rejected by those to 
whom it is offered, ceases to be money. Within the cus- 
tomary or legal limits of tolerance, however, — that is, as 
long as the cheaper money continues to be money, — it 
will tend to drive out the dearer. 

§ 2. When Bimetallism Fails 

The obvious effect of Gresham's Law is to decrease the 
purchasing power of money at every opportunity. The 
history of the world's currencies is largely a record of money 
debasements, often at the behest of the sovereign. Our 
chief purpose now, in considering Gresham's Law, is to for- 
mulate more fully the causes determining the purchasing 
power of money under monetary systems subject to the 
operation of Gresham's Law. The first application is to 
" bimetallism." Under bimetallism, governments open their 
mints to the free coinage of two metals (usually gold and 
silver) at a fixed ratio, and make both sorts of coin unlim- 
ited legal tender. For instance, if a silver dollar contains 16 
grains of silver for every grain of gold in a gold dollar, the 
ratio is said to be 16 to i. Under this system, the debtor 
has the option, unless otherwise bound by contract, of mak- 
ing payment either in gold or in silver money. These, in 
fact, are the two requisites of complete bimetallism, viz. : 
(i) the free and unlimited coinage of both metals at a fixed 
ratio, and (2) the unlimited legal tender of each metal at 
that ratio. 

In order to understand fully the influence of any monetary 
system on the purchasing power of money, we must first 
understand how the system works. It has been denied that 



Sec. a] OPERATION OF MONETARY SYSTEMS 211 

bimetallism ever did work or can be made to work, because 
the cheaper metal will drive out the dearer. Our first task 
is to show, quite irrespective of its desirability, that bi- 
metallism can and does " work " under certain circum- 
stances, but not under others. To make clear when it will 
work and when it will not work, we shall state the effects of 
a bimetallic law first in words and then, for the sake of 
greater clearness and exactness, in terms of a mechanical 
illustration. 

Suppose that, at first, gold alone is freely coined and 
unlimited legal tender and that then (as proposed in the 
United States by the ''free silver" party in 1896 and 
1900) silver is put on exactly the same basis, the mints 
being opened to its free coinage. A gold dollar weighs 
25.8 grains and a silver dollar 412.] grains or almost exactly 
sixteen times as much. Thus the " coinage ratio " is 16 
to 1. 

The results of thus opening the mints to silver at a ratio 
of 16 to 1 with gold will be different according to the rela- 
tive market value of gold and silver before the mints are 
opened. If silver is dearer than gold, there will be no 
effect, for no one will take 41 2 \ grains of silver to be coined 
and used as a dollar of money when he can get more than 
a dollar for it by selling it as silver bullion. 

But if (as happens to be the case to-day) silver is cheaper 
than gold, every owner of silver bullion will make a profit 
by taking it to the mint. In this way he can get a dollar 
for every 412.} grains of silver, while in the silver bullion 
market he can get only, let us say, fifty cents. The result 
will be a wild scramble among all owners of silver bullion 
to get it coined, in order to transform each 412^ grains of 
it into a full-fledged dollar instead of the fifty cents which 
previously was all they could get for it. 

But, by Gresham's Law, this cheap silver money will drive 
the dearer gold money out of circulation — either abroad 
or into the melting pot or both. If there is a sufficient 



212 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

amount of silver bullion available, it will drive gold com- 
pletely out of circulation, and the country which enacted 
the law will find itself converted from a gold standard 
country into a silver standard country. There are many 
historical examples of such a result, both in the United 
States and elsewhere. 

But even when bimetallism thus fails of its object (keep- 
ing both metals in circulation, with silver and gold dollars 
of equal value), it will, nevertheless, have the effect of mak- 
ing them more nearly equal. A tendency toward equaliza- 
tion will come about from two causes, one the fact that 
from the world's stock of silver bullion there is suddenly 
drained off a great mass of silver {i.e., the silver turned 
into coin), thus making the silver bullion left both scarcer 
and dearer; and the other the fact that to the world's 
stock of gold bullion there is suddenly added a great mass 
of gold {i.e., the gold melted from coin), thus making the 
gold bullion more abundant and cheaper in its purchasing 
power over other things. The result is that, though the 
law has failed to raise 41 2 1- grains of silver from the equiva- 
lent of half a dollar of gold to the equivalent of a whole 
dollar of gold, it may raise it a little, although even this 
slight rise will not all be permanent after the silver and 
gold mines have responded to the new conditions. For 
the former will increase and the latter decrease their 
output. 

These effects can be more exactly shown by means of 
the mechanical illustration of the last chapter, in which 
the amount of gold bullion is represented by the contents of 
reservoir G b (Figs. 13, 14). Here, as before, we represent 
the purchasing power or value of gold by the distance of 
the liquid level below the zero level, 00. In the last chapter, 
our figure represented only one metal, gold, and repre- 
sented that metal in two reservoirs — the bullion reservoir 
and the coin reservoir. We shall now, one step at a time, 
elaborate that figure. First we add a reservoir for silver 



Sec. 2] 



OPERATION OF MONETARY SYSTEMS 



213 



bullion (S b ), a reservoir of somewhat different shape and 
size from G b . This reservoir may be used to show the 
relation between the value or purchasing power of silver 
and its quantity and as bullion. 

Here, then, are three reservoirs. At first the silver one 
is entirely isolated. For the present, let us suppose that the 
middle one, which contains money, is filled with gold money 




only (Figs. 13a, 14a), no silver being yet used as money. 
In other words, the monetary system is the same as that 
discussed in the last chapter. The only change we have 
introduced is to add to the picture another reservoir (S b ), 
entirely detached, showing the quantity and value of silver 
bullion. 
We next suppose a pipe opened at the right, connecting 



214 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

S b with the money reservoir ; that is, we introduce bimetal- 
lism. These new conditions are represented in Figure 136, 
where a pipe gives silver an entrance into the money or 
central reservoir. 

What we are about to represent are not the relations be- 
tween mines, bullion, and arts, but the relations between 
bullion (two kinds) and coins. We may, therefore, dis- 
regard for the present all inlets and outlets except the 
connections between the bullion reservoirs and the coin 
reservoir. 

Now in these reservoirs the surface-distances below 00 
represent, as we have said, purchasing power of gold and 
silver. But each unit of silver (say each drop of silver 
liquid, whether as money or as bullion) contains sixteen times 
as many grains as each unit of gold (say each drop of gold 
liquid, whether as money or as bullion). We all know, of 
course, that a silver dollar is much larger than a gold dollar. 
But for the sake of our mechanical representation we may 
disregard this difference, and regard a drop of gold (whether 
money or bullion) as occupying equal space with a drop of 
silver (money or bullion). That is, a unit of liquid repre- 
sents a dollar of gold or a dollar of silver. 

The liquids representing gold and silver money are 
separated by a movable film. In Figure 13a this film is at 
the extreme right; in Figure 13&, at the extreme left; in 
Figure 14a, again at the right ; and in Figure 14b, midway. 
The a figures represent conditions before the mints are opened 
to silver. The b figures represent conditions after they have 
been opened and Gresham's Law has operated. If, just pre- 
viously to the introduction of bimetallism, the silver level 
in S b is below the gold level in G b , the statute introducing 
bimetallism will be inoperative, i.e., the silver bullion will 
not flow uphill, as it were, into the money reservoir ; but if, 
as in Figure 13a or 14a, the silver level is higher, then as 
soon as the mints are open to silver it will flow into cir- 
culation. Being at first cheaper than gold, it will push out 



Sec. 2] 



OPERATION OF MONETARY SYSTEMS 



215 



the gold money through the left tube (i.e., by melting) into 
the bullion market. This expulsion of gold may be com- 
plete, as shown in Figure 136, or only partial as shown in 
Figure 146. The expulsion will continue just as long as 
there is a premium on gold ; that is, as long as the silver 
level in the bullion reservoir is above the gold level in the 
money reservoir ; in other words, as long as silver bullion 
is cheaper than gold money (comparing monetary units). 




Fig. 14. 



As soon as the connecting pipe is inserted, silver will 
flow into the money reservoir and, in accordance with 
Gresham's Law, will replace gold. Let mm, as shown in 
Figure 13a, be the mean level ; that is, a level such that, 
if the liquid in the three reservoirs should be so distributed 



2l6 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

as to have a common level, this common level would be along 
the line mm. 

Here we have to distinguish two cases : (i) when the 
silver x above the mean line, mm, equals or exceeds the total 
contents of the money reservoir below this line; (2) when x is 
less than said lower contents. These two cases are repre- 
sented by Figures 13 and 14 respectively. In the first case, it 
is evident that silver will sweep gold wholly out of circula- 
tion, as shown in Figure 13&, where the film has moved from 
the extreme right to the extreme left. This pictures what 
would have happened in the United States if we had adopted 
the free coinage of silver as proposed by one political party 
in 1896 and 1900; it also represents what actually did 
happen in the United States after the adoption of bimetal- 
lism at 15 to 1 in 1792 — the failure of bimetallism. 

But this redistribution of gold and silver which we have 
represented in the diagram is only the first effect of opening 
the mints to silver. The balance between production and 
consumption has been upset for gold and for silver. The 
increased value of silver (lowered level in S b ) has stimulated 
production, bringing into operation new silver mines (un- 
covered inlets at right) ; and, on the other hand, the de- 
creased value of gold (raised level in G b ) has discouraged 
gold production, shutting off gold mines (covered inlets at 
left). Opposite alterations are effected in the outflows, 
i.e., the consumption, waste, and absorption of each metal. 

The result is that the levels resulting from the first re- 
distribution will not necessarily be permanent. Under 
the influence of production and consumption, they may, 
and under ordinary conditions will, recede somewhat to- 
ward their original respective positions. 

§ 3. When Bimetallism Succeeds 

But let us now suppose that the original price of silver, 
instead of being 50 cents per 41 2 \ grains, is 99 centSj which 



Sec. 3l OPERATION OF MONETARY SYSTEMS 21 7 

is only slightly less than " par." While it will still be true 
that owners of silver bullion will take it to the mint, in 
order to make the profit of one cent for each 412^ grains, 
it will not require much such coinage to raise the price of 
silver to a full dollar. In that case the few new silver 
dollars coined, though they will displace some gold dollars, 
may not displace them all. As soon as enough silver 
dollars have been taken out of the stock of silver bullion to 
bring silver up to par, Gresham's law will cease to work, 
and we shall find both kinds of dollars circulating side by 
side. It is true that as soon as the silver and gold mines 
respond to the new conditions (the former increasing and 
the latter decreasing their output), the expulsion of gold 
may proceed farther; but even then it may not proceed 
far enough to cause the failure of bimetallism. 

The complicated actions and reactions here involved may 
be more precisely shown by recurring to our mechanical 
illustration. We have thus far considered the mechanism 
only for the first case, where x is larger than the contents 
of the money reservoir below mm. In the second case 
(Fig. 14), x is supposed to be smaller than the contents of 
the money reservoir below the line mm ; that is, there is not 
enough silver to push all the gold out of circulation. Under 
these circumstances, disregarding for the moment any 
change in production or consumption, the opening of the 
pipe — the opening of the mints to silver — will bring the 
whole system of liquids to the common level mm. In other 
words, the premium on gold bullion will disappear (Fig. 146), 
and its purchasing power and the purchasing power of silver 
bullion will be a mean between their original purchasing 
powers, this mean being the distance of the mean line mm 
below 00. In other words, bimetallism in this case succeeds ; 
that is, it will establish and maintain an equality for a time 
between the gold and silver dollars in the money reservoir. 

But the equilibrium we have found is a mere equalization 
of levels produced by a redistribution of the existing stocks 



2l8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

of gold and silver among the various reservoirs. It will 
be disturbed as soon as these stocks are disturbed. A per- 
manent equilibrium requires that the stocks shall remain 
the same — requires, in other words, an equality between 
production and consumption for each metal. After the 
inrush of silver from the silver bullion to the money res- 
ervoir, it is evident that the production and consumption 
of gold need no longer be equal to each other, nor need the 
production and consumption of silver be equal to each other. 
The same stimulation of silver production and discourage- 
ment of gold production will occur that occurred in the case 
considered in the last section. The result may be that silver 
will, in the end, entirely displace gold ; or again it may fail to 
do so. If a position of the film be found at which the pro- 
duction and consumption of gold are equal to each other, 
and the production and consumption of silver are likewise 
equal to each other, there will be equilibrium. But this 
equilibrium may be upset later and the film driven to the 
right or the left as new gold or silver is discovered and flows 
into the system of reservoirs from one side or the other. In 
this way, by moving the film back and forth, bimetallism may 
remain in successful operation for a long time, as, in fact, it 
did in France for three fourths of a century ending in 1873. 
But bimetallism will continue to keep gold and silver dollars 
equivalent only until the film happens sometime to be 
driven to either extreme position. Such a fate is in the end 
altogether probable. This is what happened in France 
in 1873. . 

§ 4. The " Limping " Standard 

Bimetallism is to-day a subject of historical interest only. 
It is no longer practiced; but its former prevalence has 
left behind it in many countries, including France and the 
United States, a monetary system which is sometimes 
called the " limping " standard. Such a system comes about 
when, in a system of bimetallism, before either metal can 



Sec. 4] 



OPERATION OF MONETARY SYSTEMS 



219 



wholly expel the other, the mint is closed to the cheaper of 
them, but the coinage that has been accomplished up to 
date is not recalled. Suppose silver to be the metal thus 
excluded — as in France and the United States. Any 
money of that metal already coined and in circulation is 
kept in circulation at par with gold. This parity may 
continue even if limited additional amounts of silver be 
coined from time to time. There will then result a differ- 
ence in value between silver bullion and silver coin, the 
silver coin being overvalued. This situation is represented 
in Figure 15. Here the pipe connection between the money 




Fig. 15. 



reservoir and the silver bullion reservoir has been, as it 
were, cut off, or, let us say, stopped by a valve which re- 
fuses passages of silver from the bullion reservoir to the 
money reservoir, but not the reverse (for no law ever can 
prevent the melting down of silver coins into bullion). 
Newly mined silver cannot now become money, and thus 
lower the purchasing power of money. 

On the other hand, new supplies of gold continue to affect 
the value of currency as before — the value, not only of 
the gold, but also of the concurrently circulating over- 
valued silver. If more gold should flow into the money 
reservoir, it would raise the currency level. Should this 
level ever become higher than the level of the silver bullion 



220 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

reservoir, silver would flow from the money reservoir into 
the bullion reservoir ; for the passage in that direction {i.e., 
melting) is still free. So long, however, as the currency 
level is below the silver level, i.e., so long as the coined 
silver is worth more than the uncoined, there will be no flow 
of silver in either direction. The legal prohibition prevents 
the inflow of silver, and the loss which would be sustained 
by melting prevents its outflow. 

In the case just discussed, the value of the coined silver 
will be equal to the value of gold at the legal ratio. Pre- 
cisely the same principle applies in the case of any money 
the coined value of which is greater than the value of its 
constituent material. Take the case, for instance, of paper 
money. So long as it has the distinctive characteristic of 
money — general acceptability at its legal value — and is 
limited in quantity, its value will ordinarily be equal to that 
of its legal equivalent in gold. If its quantity increases 
indefinitely, it will gradually push out all the gold and 
entirely fill the money reservoir, just as silver would do 
under bimetallism if produced in sufficiently large amounts. 
Likewise credit money and credit in the form of bank de- 
posits would have this effect. To the extent that they 
are used, they lessen the demand for gold, decrease its value 
as money, and cause more of it to go into the arts or to 
other countries. 

So long as the quantity of silver or other token money, 
e.g., paper money, is too small to displace gold completely, 
gold will continue in circulation. The value of other 
money in this case cannot fall below that of gold. For if it 
should, it would by Gresham's Law displace gold, which we 
have supposed it is not of sufficient quantity to do. The 
parity between silver coin and gold coin, under the " limp- 
ing " standard is, therefore, not necessarily dependent on any 
redeemability in gold, but may result merely from limita- 
tion in the amount of silver coin. Such limitation is usually 
sufficient to maintain parity, despite irredeemability. This 



Sec. 4) OPERATION OF MONETARY SYSTEMS 221 

is not always true, however ; for if the people should lose 
confidence in some form of irredeemable paper or token 
money, even though it were not overissued, it would depre- 
ciate and be nearly as cheap in money form as it is in the raw 
state. A man is willing to accept money at its face value 
so long as he has confidence that every one else is ready 
to do the same. But it is possible, for instance, for a mere 
fear of overissue to destroy this confidence. The payee, 
who under ordinary circumstances submits patiently to 
whatever money is a customary or legal tender, may then 
take a hand and insist on " contracting out " of the offend- 
ing standard. That is, he may insist on making all his 
future contracts in terms of the better metal — gold, for 
instance — and thus contribute to the further downfall in 
value of the depreciated paper. 

Irredeemable paper money, then, like our irredeemable 
silver dollars, may circulate at par with other money if 
limited in quantity and not too unpopular. If it is gradu- 
ally increased in amount, such irredeemable money may 
expel all metallic money and be left in undisputed posses- 
sion of the field. But though such a result — a condition 
of irredeemable paper money as the sole currency — is pos- 
sible, it has never proved desirable. On the contrary, irre- 
deemability is a constant temptation to abuse, and this fact 
alone causes business distrust and discourages long-time 
contracts and enterprises. Irredeemable paper money has 
almost invariably proved a curse to the country employing 
it. While, therefore, redeemability is not absolutely essen- 
tial to produce parity of value with the primary money, it 
is practically a wise precaution. 

The lack of redeemability of silver dollars in the United 
States is one of the chief defects in our unsatisfactory 
monetary system. Our paper silver certificates are re- 
deemable in silver dollars, but these silver dollars are not 
redeemable in gold. The absurdity of the situation consists 
in the fiction that somehow the redemption of the silver cer- 



222 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

tificates in silver dollars keeps them both at par with gold. 
The truth is that the paper would keep its parity with 
gold just as well if there were no redemption in silver. 
A silver dollar as silver is worth less than a gold dollar just 
as truly as a paper dollar, as paper, is worth less than a 
gold dollar. The fact that the silver is worth half a dollar, 
while the paper is worth only a fraction of a cent, will not 
avail in the least to make either the silver or the paper 
worth a whole dollar. A pillar which reaches halfway to 
the ceiling cannot hold the ceiling up any more than a 
pillar an inch high. The silver certificates and silver dol- 
lars keep at par with gold merely because they are not 
sufficient in quantity to displace gold. If their quantity 
should ever be made great enough, they would displace gold 
and depreciate ; and the redeemability of one of them in 
the other will not avail to prevent such depreciation. 

The system of the limping standard, now obtaining in 
the United States and some other countries, logically forms 
a connecting link between complete bimetallism and those 
" composite " systems by which any number of different 
kinds of money may be simultaneously kept in circulation. 
Most modern civilized states have solved the problem of 
concurrent circulation by using gold as a standard and 
silver, nickel, and copper chiefly as a subsidiary money, 
limited in quantity, with, in most cases, limited amounts 
of paper money, the latter being usually redeemable. The 
possible variations of this composite system are unlimited. 
In the United States at present we have a system which 
is very complicated, consisting of gold dollars freely coined, 
silver dollars, fractional silver, minor coins of nickel and of 
copper, United States notes, national bank notes, gold cer- 
tificates and silver certificates. The system is not only com- 
plicated, but objectionable in many of its features, especially 
in its lack of elasticity, which characteristic is due to the 
fact that national bank notes are based upon the national 
debt rather than upon the general assets of the bank. 



CHAPTER XIV 

CONCLUSIONS ON MONEY 

§ i. Can "Other Things Remain Equal"? 

The chief purpose of the preceding six chapters is to set 
forth the causes determining the purchasing power of money. 
This purchasing power has been studied as the effect of 
three, and only three, groups of causes. The three groups 
center on currency, on its velocity, and on the volume of 
trade. These and their effects, namely, prices, we saw to be 
connected by an equation called the equation of exchange, 
MV + M'V = 'ZpQ- The three causes, in turn, we found 
to be themselves effects of antecedent causes lying entirely 
outside of the equation of exchange, as follows : the volume 
of trade will be increased, and therefore the price level 
correspondingly decreased by the differentiation of human 
wants ; by diversification of industry ; and by facilitation 
of communication. The velocities of circulation will be in- 
creased, and therefore the price level increased by improv- 
ident habits ; by the use of book credit ; and by rapid 
transportation. The quantity of money will be increased, 
and therefore the price level increased, by the import and 
minting of money, and, antecedently, by the mining of the 
money metal ; by the introduction of another and initially 
cheaper money metal through bimetallism ; and by the issue 
of bank notes and other paper money. The quantity of 
deposits will be increased, and therefore the price level 
increased, by extension of the banking system and by the 

223 



224 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XIV 

use of book credit. The reverse causes produce, of course, 
reverse effects. 

Thus, behind the three sets of causes which alone affect 
the purchasing power of money, we find over a dozen ante- 
cedent causes. If we chose to pursue the inquiry to still 
remoter stages, the number of causes would be found to 
increase at each stage in much the same way as the number 
of one's ancestors increases with each generation into the 
past. In the last analysis myriads of factors play upon the 
purchasing power of money ; but it would be neither feasible 
nor profitable to catalogue them. The value of our analysis 
consists rather in simplifying the problem by setting forth 
clearly the three proximate causes through which all others 
whatsoever must operate. At the close of our study, as at 
the beginning, stands forth the equation of exchange as the 
great determinant of the purchasing power of money. With 
its aid we see that normally the quantity of deposit currency 
varies directly with the quantity of money, and that there- 
fore the introduction of deposits does not disturb the re- 
lations we found to hold true before. That is, it is still true 
that (i) prices vary directly as the quantity of money, pro- 
vided the volume of trade and the velocities of circulation 
remain unchanged ; .-(2) that prices vary directly as the 
velocities of circulation (if these velocities vary together), 
provided the quantity of money — and therefore deposits 
— and the volume of trade remain unchanged ; and (3) that 
prices vary inversely as the volume of trade, provided the 
quantity of money and therefore deposits and the veloc- 
ities of circulation remain unchanged. 

But the question now arises, Can the factors supposed 
to " remain unchanged " in these three cases actually remain 
unchanged ? To this question we answer, " Yes, with one 
exception." A change in the volume of trade (in a certain 
case now to be explained) will affect, besides prices, the 
velocities of circulation, so that the supposition that these 
velocities " remain unchanged " becomes untrue. The 



Sec. i] CONCLUSIONS ON MONEY 225 

case in which a change in trade effects changes in velocities 
of circulation is this : when the change in trade more than 
keeps pace with the changes in population so that it involves 
a change in per capita trade. At a given price level, the 
greater the per capita expenditure, the more rapid is the 
individual turnover. Statistics seem to show this. This 
proposition, of course, has no reference to nominal increase of 
expenditure. As we have seen, a doubling of all prices, 
wages, and salaries would not affect anybody's rate of turn- 
over of money. Each payer would need to make ex- 
actly twice the expenditure for the same actual result, and 
to keep on hand exactly twice the money in order to meet 
the same contingencies in the same way. The real ex- 
penditure of a person, on the other hand, is measured by the 
comparative quantities of things bought. 

We find, then, that an increase in trade, unlike an in- 
crease in currency or in velocities, has other effects than 
simply on prices ; for, in fact, it increases the magnitudes 
on the opposite side of the equation. But with the excep- 
tion above named, and apart from transition periods, the 
three groups of magnitudes which determine the price level 
— (1) money and deposits, (2) their velocities, (3) vol- 
ume of trade — are independent of each other ; that is to 
say, each can vary without necessitating any change in the 
other two. In particular, a change in the quantity of 
money — and therefore of deposits — causes an exactly 
proportional change in prices without causing any change in 
velocities and trade. 

This does not, of course, prevent other causes from at 
the same time affecting M\ V, V ', and the <2's, and thus 
aggravating or neutralizing the effect of M on the />'s. But 
these are not the effects of M. So far as M by itself is 
concerned, its effect is only on the p's and is strictly propor- 
tional to its quantity. The importance and reality of this 
proposition is not diminished in the least by the fact that 
these other causes do not, as a matter of fact, remain qui- 
Q 



226 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIV 

escent and allow the effect on the p's of an increase in M 
to be seen separately from effects of other causes. The 
effects of changes in M are blended with the effects of 
changes in the other factors in the equation of exchange, 
just as the effects of gravity upon a falling body are 
blended with the effects of the resistance of the atmosphere. 

Our main conclusion, then, is that we find nothing to 
interfere with the truth of the quantity theory : that varia- 
tions in money (AT) produce, normally, proportional changes 
in prices. 

We have now finished with the principles determining 
the purchasing power of money. By the aid of these prin- 
ciples the student should be able to avoid hereafter most 
of the fallacies and pitfalls which beset the subject. He 
will find it a useful exercise to turn back to Chapter I 
and test himself by analyzing as many as he can of the money 
fallacies there stated. The others we hope to clear up in 
later chapters. 

§ 2. An Index Number of Prices 

We have been studying the causes determining the pur- 
chasing power of money, or its reciprocal, the level of prices. 
Hitherto we have not defined exactly what a " general level" 
of prices may mean. There was no need of such a definition 
so long as we assumed, as we have usually done hitherto, 
that all prices move in perfect unison. But practically, 
prices never do move in perfect unison. If some p's do not 
rise enough to preserve our equation, others must rise more. 
If some rise too much, others must rise less. The case is 
further complicated by the fact that some prices cannot 
adjust themselves at all and some can adjust themselves 
but tardily. A price fixed by contract cannot be affected 
by any change coming into operation between the date 
of the contract and that of its fulfillment. The existence of 
such contracts constitutes one of the chief arguments for a 



Sec. 2] CONCLUSIONS ON MONEY 227 

system of currency such that the uncertainties of its pur- 
chasing power are the least possible. Contracts are a 
useful device ; and an uncertain monetary standard dis- 
arranges them and discourages their formation. Even in 
the absence of explicit contracts, prices may be kept from 
adjustment by implied understandings and by the mere 
inertia of custom. And besides these restrictions on free 
movement of prices there are often legal restrictions ; as, 
for example, when railroads are prohibited from charging 
over two cents per passenger per mile, or when street rail- 
ways are limited to five-cent or three-cent fares. What- 
ever the causes of non-adjustment, the result is that the 
prices which do change will have to change in a greater ratio 
than they would were there no prices which do not change. 
Just as an obstruction put across one half of a stream 
causes an increase of current in the other half, so any de- 
ficiency in the movement of some prices must cause an 
excess in the movement of others. 

Another class of goods, the price of which cannot fluctu- 
ate greatly with other prices, are those special commodi- 
ties which consist largely of the money metal. Thus, in a 
country employing a gold standard, the prices of gold for 
dentistry, of gold rings and ornaments, gold watches, gold- 
rimmed spectacles, gilded picture frames, etc., instead of 
varying in proportion to other prices, always vary in a 
smaller proportion. The range of variation is the nar- 
rower, the more predominantly the price of the article de- 
pends upon the gold as one of its raw materials. 

From the fact that gold-made articles are thus more or 
less securely tied in value to the gold standard, it follows 
also that the prices of substitutes for such articles will tend 
to vary less than prices in general. These substitute articles 
will include silver watches, ornaments of silver, and various 
other forms of jewelry, whether containing gold or not. 

A further dispersion of prices is produced by the fact that 
the special forces of supply and demand are playing on 



228 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XIV 

each individual price, and causing relative variations among 
them, and although (as we have before emphasized) these 
variations cannot affect the general price level, they can 
affect the number and extent of individual divergencies 
above and below that general level. 

It is evident, therefore, that prices must constantly 
change relatively to each other, whatever happens to their 
general level. It would be as idle to expect a uniform move- 
ment in prices as a uniform movement for all bees in a swarm. 
On the other hand, it would be as idle to deny the existence 
of a general movement of prices because they do not all 
move alike as to deny a general movement of a swarm of 
bees because the individual bees have different movements. 

Besides these changes in individual prices, there will be 
corresponding changes in the quantities of the commodities 
which are exchanged at these prices respectively. In other 
words, as each p changes, the Q connected with it will 
change also, because usually any influence affecting the 
price of a commodity will also affect the consumption of it. 

We see, therefore, that it is well-nigh useless to speak of 
uniform changes in prices (p's) or of uniform changes in 
quantities exchanged (Q's). Therefore, instead of sup- 
posing such uniform, changes, we must now proceed to the 
problem of developing some convenient method of indicating 
by an average the general trend of the changes in prices or in 
quantities. We must formulate two composite or average 
magnitudes : the price level and the volume of trade. 

It is desired, then, in the equation of exchange, to con- 
vert the right side, 'ZpQ, into the form P T, where T measures 
the volume of trade, and P expresses the price level at which 
this trade is carried on. 

T is conceived as the sum of all the Q's, and P as the 
average of all the p's. 

To carry out these definitions in practice, suitable units 
of measure for the various articles must be selected. The 
ordinary units in which the various Q's are measured will 



Sec. 2] 



CONCLUSIONS ON MONEY 



229 



not be the most suitable. Coal is sold by the ton, sugar 
by the pound, wheat by the bushel, etc. If we should 
merely add together these tons, pounds, bushels, etc., and 
call their grand total so many " units " of commodities, we 
should have a very arbitrary summation. It will make a 
difference to the result whether we measure coal by tons 
or hundredweights. The system becomes less arbitrary 
and more useful for the purpose of comparing price levels 
in different years if we use, as the unit for measuring any 
commodity, not the unit in which it is commonly sold, but 
the amount which constitutes a "dollar's worth" at some partic- 
ular year called the base year. Then every price in the base 
year becomes exactly one dollar, and the average of all 
prices in that year also becomes exactly one dollar. In 
any other year, the average price {i.e., the average of the 
prices of the newly chosen units which in the base year were 
worth a dollar) will be the index number representing the 
price level, while the number of such units will be the volume 
of trade. Thus, let us suppose, for simplicity, that there 
are only three commodities (bread, coal, and cloth), and let 
us suppose the following facts to start with : — 





Prices (in Dollars) 


Quantities Exchanged 


Yeah 


Bread (per 
Loaf) 


Coal (per 
Ton) 


Cloth (per 
Yard) 


Bread (Mil- 
lions of 
Loaves) 


Coal (Mil- 
lions of 
Tons) 


Cloth (Mil- 
lions of 
Yards) 


1909 . . 
1911 . . 


.10 
•15 


5.00 
6.00 


1. 00 
1. 10 


200 

210 


IO 
II 


30 
35 



We wish to compare the average price or price level in 
the year 191 1 with that in 1909 as the base year, and 
also to reckon the total volume of trade in 191 1 in com- 
parison with that in 1909. If we were not desirous of taking 
great pains to secure the best results, we could use the above 
figures just as they stand — averaging the prices and adding 



230 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XIV 

together the quantities. By this rough-and-ready method 
the average price per unit for 1909 would be (.10 + 5.00 
+ 1.00) ■*■ 3, or $2.03 ; and for 1911 (.15 + 6.00 + 1.10) -s- 3, 
or $2.42 ; the total trade for 1909 would be 200 -j- 10 -f 30, 
or 240 million units; and for 1911, 210 + 11 4- 35, or 256. 
That is, the price level would show a rise between 1909 and 
1911 from $2.03 to $2.42, or a rise of nineteen and two tenths 
per cent, while the volume of trade would show a rise from 
240 to 256, or six and six tenths per cent. But the simple 
method just used gives too much weight in the price com- 
parison to coal, which has a high price simply because it is 
measured by a large unit. One way to remedy this dis- 
proportionate weighting is to measure all articles by one 
unit, as the pound; but a better way is that already de- 
scribed above, viz., to use as our unit " the dollar's worth 
in 1909." The dollar's worth of bread in 1909 was evi- 
dently ten loaves, the dollar's worth of coal, the fifth of a ton, 
and that of cloth, the yard. Taking these units, we now 
have : — 





Prices (in Dollars) 


Quantities 


Year 


Bread (per 
Ten Loaves) 


Coal (per 
£Ton) 


Cloth (per 
Yard) 


Bread (Mil- 
lions of Ten 
Loaves) 


Coal (Mil- 
lions of £ 
Tons) 


Cloth (Mil- 
lions of 
Yards) 


1909 . . 
1911 . . 


1.00 

1.50 


1.00 

1.20 


1.00 

I.IO 


20 

21 


55 


30 
35 



The average price in 1909, on the basis of these new units, 
is simply $1, since this is the price of each individual article ; 
while the average price in 191 1 is — if we take the simple 
arithmetical average — ($1.50 + $1.20 + $1.10) -f- 3, or $1.27. 
The total volume of trade in 1909 is (in millions of units) 
20 + 50 + 30, or 100; and in 1911, 21 + 55 +35, or in. 
Thus, according to this reckoning, the price level has risen 
from $1.00 to $1.27, or, as it is usually expressed, from a base 



Sec. 2] CONCLUSIONS ON MONEY 231 

of one hundred per cent to a height of one hundred and 
twenty-seven per cent — a rise of twenty-seven per cent ; 
while trade has increased from 100 million units to in 
million units, an increase of eleven per cent. 

We may slightly improve the above method by taking a 
" weighted " average of prices instead of a simple average. 
This will give less weight to bread in the result. The 
average for 1909 will still be $1.00, for that is the price for 
each individual commodity; but the average for 191 1 will 
be slightly different. It is found by dividing the total 
value of all the goods by their total quantity. The total 
value is (in millions of dollars) 1.50 X 21 + 1.20 X 55 
+ 1. 10 X 35, or 136 million dollars, and the total quantity 
is, as we have already seen, 21 + 55 + 35, or in million 
units; consequently the average price is 136 4- 111, or 
$1.23. Thus, according to this last and best method the 
price level has risen from $1 (or one hundred per cent) 
to $1.23 (or one hundred and twenty- three per cent) ; 
this indicates a rise of twenty-three per cent. 

The results of the three methods of reckoning the average 
rise of prices differ slightly, showing respectively a rise of 
nineteen, twenty-seven, and twenty-three per cent. Other 
methods, of which many are possible, would also differ 
slightly. No method gives an absolutely perfect index of 
changes in price levels, but the last one given is as good 
as any. The main point in any system of averages is to 
give great weight to the great staples of trade, and little 
weight to the insignificant articles. Radium has fallen 
in price enormously in the last few years, but radium is so 
unimportant as an article of commerce that its great fall 
ought not to be allowed in our reckoning to have much 
effect on the index number for the average price level. 

Introducing, then, our newly found magnitudes, P and 
F, into the equation of exchange, it assumes the form 

MV + M'V = PT, 



232 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIV 

its right member being the product of the index number, 
P (or the average of prices) multiplied by the volume of 
trade, T (or the sum total of " units " sold). 

§ 3. The History of Price Levels 

It is impossible to have absolutely accurate index num- 
bers, but those constructed for recent years by the United 
States Bureau of Labor are accurate enough for all practical 
purposes. For the remote past we have only very rough 
index numbers, because the records of prices in past times 
are so defective. These rough index numbers are suffi- 
cient, however, to show that the general trend of prices dur- 
ing the last ten centuries has usually been upward. We 
may say that prices are now five to ten times as high as a 
thousand years ago. Since the discovery of America, prices 
have almost steadily risen. The successive opening of 
mines has been largely responsible for this rise. 

For the most recent years (1896-19 10) we are able to 
construct fairly accurate estimates of all the factors in the 
equation of exchange, M, M' , V, V', P, T. The statistics 
of these magnitudes for the fifteen years mentioned are all 
presented in Figure 16. In this diagram the equation of 
exchange for each year is represented by the mechanical 
balance described in a previous chapter. 

We note that every factor has greatly increased in the 
years considered. The quantity of money in circulation 
(M, represented by the purse) has about doubled; bank 
deposits subject to check (M f , represented by the bank 
book) have about trebled; the volume of trade (T, repre- 
sented by the weight at the right) has about doubled ; the 
velocity of circulation of money (V, represented by the 
leverage of the purse, or its distance from the fulcrum) has 
increased slightly, and the velocity of circulation of bank 
deposits ( V', represented by the leverage of the bank book) 
has increased considerably. As the net result of. these 



_o 




LO 

Lo 
;<d 

Lo 



:o 



LO 



D 




► -^ 



>3 



Sec. 3] CONCLUSIONS ON MONEY 233 

changes, the index number of prices (P, or the leverage of 
the weight at the right) has increased about two thirds. 
The price level of 1909 is taken as one hundred per cent. 
On this scale the price level of 1896 is sixty per cent, and 
that of the other years, as indicated. The volume of trade 
for any year is represented as the number of " dollars' 
worth " on the basis of the prices in 1909. Thus the actual 
value of trade in 1909 was $387,000,000,000, or over a bil- 
lion a day, i.e., 387 billion units each worth one dollar. 
The trade in 1910 was $399,000,000,000 worth, reckoned, 
of course, at the prices of igog, not at the prices of 1910. 
Similarly the trade in 1896 was $191,000,000,000 worth, 
reckoned at the prices of igog, not at the prices of 1896. 
At the prices of 1896 the value of the trade in 1896 was 
only $114,600,000,000. This is PT for 1896, i.e., 191 
billion units (each worth $1 in 1909) at 60 cents each, the 
price in 1896. 

Let us express the matter in terms of cause and effect. 
The diagram affords a picture of the fact that the increases 
in money and deposits and in their velocities (represented, 
respectively, by the increased weights of purse and bank 
book, and their increased distances from the fulcrum) have 
necessitated an increase in average prices (represented by the 
increased distance of the tray from the fulcrum) in spite of 
the increased volume of business which has been transacted 
(represented by the increased weight of the tray). 

It is interesting to observe the changes in all the factors 
before and after the crisis of 1907. These changes, it will 
be noted, fulfill the principles explained in the chapter on 
crises. 

From 1896 to the present time, the extraordinary increase 
in the world's gold production, chiefly in South Africa, 
Cripple Creek, and other parts of the Rocky Mountain 
Plateau, together with the Klondike region, has caused, 
and is still causing, a rapid rise of prices. 

The history of prices has in substance been a race between 



234 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIV 

the increase in media of exchange (M and M') and the 
increase in trade (T), while the velocities of circulation 
have changed in a much less degree. Sometimes the 
circulating media shoot ahead of trade, and then prices 
rise. Sometimes, on the other hand, circulating media 
lag behind trade, and then prices fall. 

The outlook for the future apparently promises a con- 
tinued rise of prices due to a continued increase in the gold 
supply. 

The most careful review of present gold-mining conditions 
shows that we may expect a continuance of gold inflation 
for a generation or more. De Launay, an excellent authority, 
says, " For at least thirty years we may count on an output 
of gold higher than, or at least comparable to, that of the 
last few years." This gold will come from the United 
States, Alaska, Mexico, the Transvaal, and other parts of 
Africa and Australia, and later from Colombia, Bolivia, 
Chili, the Ural Province, Siberia, and Korea. 

It is difficult to predict the future growth of trade, and 
therefore impossible to say for how long gold expansion 
will keep ahead of trade expansion. That for many years, 
however, gold will outrun trade seems probable, for the 
reason that there is no immediate prospect of a reduction 
in the percentage growth of the gold stock, nor an increase 
in the percentage growth of trade. Not only do mining 
engineers report immense workable deposits in outlying 
regions (for instance, a full billion of dollars in one region 
of Colombia alone), but any long look ahead must reckon 
with possible and probable cheapening of gold extraction. 
The cyanide process, for instance, has made low-grade ores 
pay which did not pay before. If we let imagination run 
a little ahead of our times, we may expect similar improve- 
ments in the future whereby still lower grades may be 
worked, or possibly the sea compelled to give up its gold. 
Like the surface of the continents, the waters of the sea con- 
tain many thousand times as much gold as all the gold thus 



Sec. 3] CONCLUSIONS ON MONEY 235 

far extracted in the whole history of the world. We have 
seen that inflation is, in general, an evil, likely to culminate 
in a crisis. It is therefore to be hoped that the knowledge 
of how to get this hidden treasure may be secured but 
gradually. 

It is unfortunate that the purchasing power of money 
should be always at the mercy of every chance in gold 
mining. There are few enterprises more subject to chance 
than gold mining. There are always chances of rinding 
new gold deposits, chances of their " panning out " well or 
ill, and chances of new methods of metallurgy. On these 
fitful conditions the purchasing power of money is dependent. 
Consequently every one interested in long-time contracts, 
whether debtor or creditor, stockholder or bondholder, wage 
earner or savings bank depositor, is made to some extent 
a partaker in these chances. In a sense every one of us who 
uses gold as a standard for deferred payments becomes a 
gold speculator. We all take our chances as to what the 
future dollar will buy. The problem of making the pur- 
chasing power of money stable so that a dollar may be a 
dollar — the same in value at one time as another — is one 
of the most serious problems in applied economics. As yet 
it has received very little attention. The advocates of 
bimetallism have claimed that " the bimetallic standard " 
possesses greater stability than either the gold or silver 
standard. Many other and very ingenious schemes for 
a more stable currency have been proposed, but have re- 
ceived very little attention. As the consideration of these 
schemes belongs to applied economics, we shall not discuss 
them here. 



CHAPTER XV 

SUPPLY AND DEMAND 

§ i. Individual Prices Presuppose a Price Level 

We have completed our study of the purchasing power of 
money, which, as has been noted, is really a study of price 
levels. Our next topic will be individual prices. It has 
already been shown that individual prices, such, for instance, 
as the price of sugar, presuppose a price level. This fact is 
one reason why we have considered price levels before con- 
sidering individual prices. 

Before proceeding to the causes determining individual 
prices, it will be advisable to explain more fully the propo- 
sition that an individual price presupposes a price level. 

The price of sugar is a ratio between sugar and money. 
Any one who buys sugar balances in his mind the impor- 
tance of the sugar to him against the importance of the 
money which he has to pay for it. In making this com- 
parison, the money stands in his mind for the other things 
which it might buy if not spent for sugar. If the purchas- 
ing power of money is great, it will seem precious in his mind, 
and he will be more loath to part with a given amount of it 
than if its purchasing power is small ; that is, the greater 
the power of money to purchase things in general, the less of 
it will be offered for sugar in particular, and the lower the 
price of sugar will therefore become. In other words, the 
lower the general price level, the lower will be the price of 
sugar. In still other words, the price of sugar must sym- 

236 



Sec. 2] SUPPLY AND DEMAND 237 

pathize with prices in general. If they are high, it will tend 
to be high, and if they are low, it will tend to be low. Be- 
fore the purchaser of sugar can decide how much money 
he is willing to exchange for it, he must have some idea of 
what else he could buy for his money. This explains why 
a traveler feels at first so helpless in a foreign country when 
he is told the prices of goods in terms of unfamiliar units. 
If the traveler has never heard before of kroner, gulden, 
rubles, or milreis, any prices expressed in these units will 
mean nothing to him. He cannot say how many of any one 
of these units he is willing to pay for any given article until 
he knows how the purchasing power of that unit compares 
with the unit to which he is accustomed. There must thus 
always be in the minds of those who use money some idea 
of its purchasing power. The sellers and buyers of sugar 
express the amounts they are willing to supply or to demand 
in terms of money, and money means to them merely pur- 
chasing power over other things. It is often said that supply 
and demand of sugar or of any other commodity determine 
its price, and this is true, provided a price level is first as- 
sumed. This proviso needs emphasis because it is so often 
overlooked. Although the purchasing power of money is 
assumed, we are usually as unconscious of it as we are of the 
background of a picture against which we see and uncon- 
sciously measure the figures in the foreground. 

§ 2. A Market and Competition 

The terms " supply " and " demand," say, of sugar, 
thus imply a concealed reference to the purchasing power 
of money, i.e., to prices in general, as well as to the price of 
sugar in particular. As we have, through several previous 
chapters, already studied the subject of prices in general, 
we shall hereafter assume that the general level of prices 
has been determined in accordance with the principles set 
forth in those chapters relating to the equation of exchange. 



238 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 

We are now ready to leave these general relations and to 
study the determination of a particular price (such as that 
of sugar) so far as this depends upon its own particular 
supply and demand in its own particular market. 

A market for any commodity or good is any assemblage 
of buyers and sellers of that commodity or good. The 
buyers and sellers may be, and usually are, physically near 
each other, as on the New York Stock Exchange, or they may 
be merely connected by telegraph, telephone, or other means 
of communication, as in the stock market as a whole ; for 
the stock market as a whole includes not only the members 
of the stock exchange, but also all other buyers and sellers 
of stock both in and out of the city. It is in the market that 
questions of supply and demand which we are about to 
discuss work themselves out. 

Our study of price determination will fall under two 
heads, according as there is competition or monopoly. 
For the present we shall assume a condition of perfect 
competition; that is, we shall assume that there are a 
number of buyers and sellers each of whom offers to buy 
or sell independently of the others. Thus, if self-interest 
leads him to do so, a buyer will bid a higher price than 
others, irrespective of their wishes in the matter, and 
likewise a seller will ask a lower price if his independent 
self-interest so leads him. 

When there is perfect competition, there is only one price 
for all buyers and all sellers. This is evident ; for if there 
were more than one, no buyers would buy at the higher 
prices which had first been asked (and so these must there- 
fore fall) , and no seller would sell at the lower prices which 
had been bidden (and so these must therefore rise). The 
watchfulness of one competitor toward the others will 
eliminate differences in price. Even though not all buyers 
and sellers are careful to note slight differences in price, 
the more watchful bring about the same result by be- 
coming " speculators." They buy at the lowest prices and 



Sec. 3] SUPPLY AND DEMAND 239 

sell at the highest. Their buying raises the lowest prices, 
and their selling lowers the highest. 

In these ways differences in prices are reduced or entirely 
eliminated. It is true that in practice there often remain 
slight differences in price, even in the same or closely as- 
sociated markets. This fact merely means that competi- 
tion is often imperfect. In our discussion we shall not take 
account of those cases, but consider only the simple case 
where competition is perfect. 

§ 3. Demand and Supply Schedules 

The terms " supply " and " demand " have a definite and 
technical meaning in economics, and the reader should note 
the following definitions carefully. 

In any market there is a different demand for sugar at 
different prices. We may define the demand at a given 
price as the amount of sugar which people are willing to 
buy at that price. In the same way the supply at a 
given price is the amount which people are willing to 
sell at that price. If the price of sugar is 8 cents a pound, 
the demand for sugar in a given community at a given time 
may be, let us say, 900 pounds a week. If the price falls 
to 7 cents, the demand would increase, say, to 940 pounds. 
If the price falls to 6 cents, the demand would rise, say, to 
1000 pounds ; and so on. The supply of sugar, we shall sup- 
pose, changes in the opposite way. At 8 cents it may be 
1 100 pounds ; at 7 cents, 1050 ; at 6 cents, 1000 ; etc. The 
following table shows these figures and others, and con- 
stitutes what are called " schedules " of demand and supply 
in relation to various prices. 

The schedule of demand is the second column considered 
relatively to the first. It shows the largest quantity which 
will be taken at each given price, or, what amounts to the 
same thing, the highest price at which a given quantity will 
be taken. When the relationship between the two columns 



240 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



is expressed in the latter of these two ways, it is more con- 
venient to place the second column first, and the first, second ; 
but their order is immaterial. It is their relation to each 
other which constitutes the demand schedule. 



Price 


Schedule of 


Schedule of 


Demand 


Supply 


.08 


900 


I IOO 


.07 


940 


1050 


.06 


IOOO 


IOOO 


.05 


I IOO 


900 


.04 


1250 


75° 



In the same way the relation between the first and third 
columns constitutes the supply schedule. This tells us the 
largest quantities which will be supplied at stated prices, 
or, what amounts to the same thing, the lowest prices at 
which stated quantities will be supplied. 

Running the eye down the table, we see that, although 
the supply at first exceeds the demand, as the price falls 
demand increases and the supply decreases, until, when 
the price reaches 6 cents, the supply and demand are equal. 
For prices lower than 6 cents we find the reverse condition, 
demand exceeding supply. 

If the foregoing figures represent the demand and supply 
schedules showing the amounts that buyers are willing to 
take and sellers to give at different prices, it is clear that there 
is only one price that will make supply and demand equal. 
That price is 6 cents, and that is the price that supply and 
demand will finally fix. The price cannot long be above 
6 cents, for then supply would exceed demand, and the 
price would immediately fall. Nor can it be below, for then 
demand would exceed supply, and the price would rise. For 
instance, if the price were 8 cents, the supply (1 100 pounds) 
would exceed the demand (900 pounds) by 200 pounds. 



Sec. 4] 



SUPPLY AND DEMAND 



241 



Those wishing to sell this extra amount would then be unable 
to do so except by offering it at a lower price, and their com- 
petition would drive the price down. On the other hand, 
if the price were 4 cents, the demand (1250 pounds) would 
exceed the supply (750 pounds) by 500 pounds, and those 
demanding this extra amount would be unable to get it ex- 
cept by bidding a higher price, and their competition would 
then drive the price up. 

Since, then, the price cannot really be either above or 
below 6 cents, it must be finally fixed at 6 cents. A price 
which thus makes supply and demand equal is said to 
" clear the market," and is called the market price. The 
amounts supplied and demanded at the market price are 
called the amount marketed, i.e., the amount actually bought 
by buyers and sold by sellers. 



§ 4. Demand and Supply Curves 

The relations discussed in Section 3 can be seen more 
clearly by means 
of a diagram. In 
Figure 17 is rep- 
resented the de- 
mand for sugar at 
different prices. 

As in previous 
diagrams, the two 
axes OX and OY 
are drawn simply 
for reference, like 
the equator and 
the Greenwich 
meridian in a 
map. The inter- 
section of the two axes is called the " origin." The 
diagram is a " map " of demand on which the " latitude," 



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II 

10 
9 

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7 

6 
5 
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242 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 

or the distance above the line OX, represents any price ; 
and the "longitude," or the distance to the right of the line 
OY, represents the amount demanded at that price. Let 
us, for instance, represent an assumed price, say 8 cents, 
by measuring off the " latitude " Oy from the origin O. 
The demand at this price of 8 cents, which we have seen 
to be 900 pounds, is represented by the " longitude " yD. 
We have thus located a point D, the " latitude " of which 
represents a particular price (8 cents), and the "longitude" 
of which represents the demand (900 pounds) at that 
price. It will be seen that the " latitude" is simply the 
elevation above the base axis OX, whether we measure 
this " latitude " by the line Oy or by xD. Likewise the 
" longitude " is simply the distance of D to the right of 
the axis OY, whether this distance be measured by yD or 
by Ox. Having found one point, D, the " latitude " and 
" longitude " of which represent, respectively, a price and 
the demand at that price, we may find in like manner 
other points, the " latitudes " and " longitudes " of which 
will represent other particular prices and the demands 
corresponding to those prices. Several such points are 
indicated in Figure 17. It will be seen that the lower in 
the diagram the points, the farther they are to the right. 
This represents the fact that the lower the price, the greater 
the demand. We may suppose the spaces between those 
various points to be filled by other points, all together form- 
ing what is called the demand curve. 

A demand curve, then, is a curve such that the " latitude " 
of any one of its points represents a particular price, and the 
"longitude" of that point the particular demand correspond- 
ing to that price. Thus a demand curve is a graphic picture 
of a demand schedule. 

In precisely the same way we may treat supply. In 
Figure 18 let us represent any particular price, say 8 cents, 
by the " latitude " Oy, and the supply corresponding to 
this price (1100 pounds) by the "longitude" yS. Thus 



Sec. 4] 



SUPPLY AND DEMAND 



243 



Y 








1 


1 




! 


1 
























































































































































8 
























S 










5/ 






























6 

5 








































































































































































































































O 




ac 


X) 


<w 


JO 


6 


■jo 


800 


IOOO X «200 




X 



Fig. 18 (Supply). 



we locate a point 5 such that its " latitude " (Oy or xS) 
represents a particular price, and the " longitude" (yS or 
Ox) represents the 
supply at that 
particular price. 
In like manner 
we may locate 
other points, the 
"latitudes" of 
which represent 
other prices and 
the "longitudes" 
of which repre- 
sent the amounts 
which would be 
supplied at these 
respective prices. 
These points are so arranged that the higher their " lati- 
tude," the greater their " longitude." This represents our 

assumption that 
the higher the 
price, the greater 
the supply. The 
curve which these 
points form is 
called a supply 
curve and is a 
graphic picture of 
a supply schedule. 
In Figure 19 
are drawn both 
the supply and 
the demand 
curves, the de- 
mand curve being DD f , and the supply curve, SS'. We 
have seen that the demand curve shows many different 



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p m 




















D" 




fe 










































p' 






















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s 




3" 










D'" 




D 











































































































































K 



Fig. 19. 



244 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 

demands at many different prices, and that, similarly, the 
supply curve shows many different supplies at many dif- 
ferent prices; but that there is only one price at which sup- 
ply and demand are equal. We can see this clearly in 
Figure 19, for there is only one point (P) in which the 
two curves intersect. The " latitude " (OP') of the inter- 
section (P) of the curves DD f and SS' represents the 
market price. The " longitude "of P represents the 
amount marketed, which is at once the supply at that price 
and the demand at that price. The point P may be called 
the market point. 

The market price, OP' , clears the market, and no other 
price will. If, for instance, we take a higher price, such 
as OP", the supply will be represented by the long line 
P"S", and the demand by the short line P"D", leaving the 
distance between them, or D"S" , as the excess of supply 
over demand. The effort of sellers to get rid of this excess 
will drive the price down. Thus the market price cannot 
exceed OP' . In like manner, the market price cannot be 
lower than OP' . If, for instance, it were only OP'" , the 
demand would be P'"D'", and the supply only P"'S"', 
leaving an excess of demand over supply of D'"S'" , which 
at that price the buyers are unable to obtain. They will 
therefore bid up the price. We see, then, that the only real 
price is OP'. The point P, at which the two curves in- 
tersect, is the only real point the latitude of which repre- 
sents the market price and the longitude the actual amount 
demanded and sold. All the other points in the two curves 
are hypothetical, representing, not what demand and supply 
actually are, but what they would be at other prices than the 
real market price. 

All demand curves descend to the right. But they de- 
scend at different rates. Those demand curves which de- 
scend very rapidly represent the demand schedules of those 
goods which are called necessities, for the rapid descent 
means that it requires a great fall of price to affect demand 



Sec. 5] 



SUPPLY AND DEMAND 



245 



materially. We know that demand for necessities such as 
salt does not change greatly, even if the price changes much. 
At the other extreme are luxuries, the demand curves 
of which descend very slowly, thus interpreting the fact 
that a slight fall in price produces a great expansion in de- 
mand. If the price of champagne, for instance, is slightly 
changed, the amount of it consumed will be materially 
affected. 

In the same way supply curves may ascend at different 
rates, those ascending speedily being commodities the sup- 
ply of which cannot expand very much, even with a great 
increase in price. At the opposite extreme are the supply 
curves which ascend very slowly, being those of commodities 
the supply of which can be greatly increased by only a small 
increase in price. 

Most of the articles produced in extractive industries 
such as agriculture or mining are of the rapidly ascending 
type, while manufactured articles often illustrate the 
slightly ascending type. It requires a great increase in 
the price of coal to materially affect the output of coal 
mines, but it requires only a slight rise in price of manu- 
factured products to lead to an enormous increase in the 
output. 



§ 5. Shifting of Demand or Supply 



Having represented sup- 
ply and demand by curves, 
we are now in a position to 
understand more clearly 
what is meant by " in- 
crease of demand " or "in- 
crease of supply." These 
phrases are often used 
loosely, without realization 
that they are ambiguous. 



Y 




Fig. 20 (Demand). 



246 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 








2 



Fig. 21 (Demand). 



Increase of demand, for instance, may mean one of two 
things. It may mean a shifting of the market point from 

one position A to another 
I A B position B, farther to the 

right, on the same demand 
curve (Fig. 20), or it may 
mean a shifting of the entire 
demand curve from the posi- 
tion A to the position B, 
farther to the right (Fig. 21). 
Both of these meanings 
are admissible, but they are 
entirely distinct. In the 
same way, " increase of sup- 
ply " may mean one of two things, either a shifting of the 
market point A to another position B, farther to the right, 
on the same supply curve (Fig. 22), or a shifting of the 
entire supply curve from 
the position A to the posi- 
tion B farther to the right, 
as in Figure 23. 

We see, therefore, that 
an "increase of supply" 
or of demand may mean 
either a change of the 
point on the same curve 
or a change of the curve 
itself. To distinguish their 
two meanings we shall call 
the first an increase in the 








Fig. 22 (Supply). 



point sense and the second an increase in the curve sense. 
We shall find that the curve sense is the more important 
and fundamental. So important is the distinction between 
these two senses of an increase of supply or demand (i.e., 
an increase in the point sense and in the curve sense) that 
it will be worth our while to express the distinction in 



Sec. 5] 



SUPPLY AND DEMAND 



247 








B— 



Fig. 23 (Supply). 



terms independent of the diagrams. An increase in de- 
mand, in what has just been called the " point sense," 
means, in ordinary lan- 
guage, an increase in de- I 
mand in consequence of a 
decrease in price, and with- 
out any change in the de- 
mand at any particular 
price. For instance, if the 
demand for sugar at 8 cents 
is 800 pounds and the de- 
mand at 4 cents is 1250 
pounds, a fall in price from 
8 cents to 4 cents will in- 
crease the demand from 
900 pounds to 1250 pounds. An increase of demand in the 
curve sense, on the other hand, means an increase in the 
demand at each price. For instance, if at one time the 
demand for sugar at 8 cents per pound is 900 pounds, 
but, later, the demand at this same price (8 cents) becomes 
1000 pounds, it is clear that the demand has increased 
without any change in price ; and, if the demand has like- 
wise increased for every other price (than the 8 cents which 
we took for an illustration), the demand is said to have 
increased in the curve sense. 

Recurring to " price schedules," an increase of demand 
in the point sense means merely a passing from one figure in 
the demand column to another figure farther down, as, for 
instance, from the top to the bottom of the table given in 
Section 3 ; while an increase of demand in the curve sense 
means an increase in all the figures in the column headed 
" demand." In the first case there is no change of the 
demand schedule ; in the second case there is. 

In the same way, an increase of supply in the point sense 
means an increase in supply in consequence of an increase 
in price. For instance, if the supply of sugar at 4 cents 



248 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 

a pound is 750 pounds and at 8 cents, 1100 pounds, then 
a change in price from 4 cents to 8 cents will cause the supply- 
to increase from 750 pounds to n 00 pounds. An increase 
of supply in the curve sense, on the other hand, means an 
increase of the supply at any given price, as would be the 
case if the supply at 4 cents should change from 750 pounds 
to 800 pounds, and at 8 cents, from 1100 pounds to 1200 
pounds. In terms of the supply schedule, an increase of 
supply in the point sense merely means a passage from, 
say, the bottom to the top of the supply column in Sec- 
tion 3 without any change in that column ; while an in- 
crease of supply in the curve sense means an increase in 
all the figures of the supply column. 

It would be possible to employ other terms to distinguish 
the two senses of increased supply and demand which we 
have chosen to distinguish by the contrasted terms "point" 
and "curve," but as the distinction is most clearly pictured 

by diagrams, and, as it is 
highly important to think in 
terms of diagrams, it seems 
best to employ the language 
of diagrams. 

It will be seen that an 
increase of demand in the 
point sense is nothing else 
than an increase of supply 
in the curve sense ; for we 

« have already made it clear 

FlG that there is only one point 

which is the intersection of 
the two curves, and that this point cannot be shifted to 
the right from A to B on the demand curve unless the 
whole supply curve has shifted so as to change the inter- 
section. Such a shifting is seen in Figure 24. Here the 
demand has increased in the point sense, having changed 
from A to B on the same demand curve ; but this increased 




Sec. 5] 



SUPPLY AND DEMAND 



249 




Fig. 25. 



demand comes about only because the supply has increased 
in the curve sense, having shifted from the position of the 
unbroken supply curve to _._ 
the position of the dotted 
curve. 

Again, to say that sup- 
ply has increased in the 
point sense is the same 
thing as to say that the 
demand has increased in 
the curve sense. This is 
shown in Figure 25, 
where the point A on 
the supply curve has 
shifted to B on the same 
curve, because the demand curve had shifted from the 
unbroken to the dotted position. 

We should, therefore, be careful to know, when we speak 
of a change in demand or supply, whether we mean that the 
change is in the point sense or in the curve sense. It seems 
odd at first to think that the increase of demand in one sense 
is really an increase of supply in another sense, and vice 
versa. Because of this ambiguity, when one person speaks 
of an increase of supply, it means the same thing as when 
another speaks of an increase of demand. 

To illustrate the two meanings, let us suppose that the 
demand curve considered is the demand curve for automobiles, 
and that, given the same prices, people would demand auto- 
mobiles now no more and no less than they did a few years 
ago, but that the condition of the supply has changed, so that 
now more automobiles can be supplied for the same price. 
That would mean that the supply curve had shifted to the 
right, so that its point of intersection with the same demand 
curve has also shifted to the right (Fig. 24) . Therefore two 
things have happened on the demand side. The price has 
fallen, and as a consequence of that fall of price the num- 



250 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 

ber of automobiles demanded has increased. Demand in 
the point sense has increased. But demand in the curve 
sense has not changed at all. People are just as willing as 
before to take an automobile at $4000, but they are will- 
ing to take more automobiles at present low prices than 
at former high prices. There have been no changes in the 
conditions of demand, i.e., the demand schedule. What 
have changed are the conditions of supply, i.e., the supply 
schedule. 

On the other hand, we might take as our illustration works 
of art. In the past few years there has been a great change 
in the attitude of Americans toward works of art. Of these 
we are much more appreciative than we used to be, and are 
willing to pay more, for instance, for a fine painting than 
previously. Thus, for works of art the demand curve 
has shifted; the demand for works of art has increased 
in the curve sense (Fig. 25). Consequently, the supply has 
increased in the point sense; namely, on account of the 
greater demand the price has risen, and therefore owners 
and makers of works of art have offered more for sale. 

Thus increase of demand in the curve sense brings about 
increase of supply in the point sense, and vice versa. An 
increase in the supply of automobiles in the curve sense 
brought about an increase in the demand for automobiles 
in the point sense, while an increase in the demand for works 
of art in the curve sense brought about an increase in the 
supply of works of art in the point sense. In either case 
the ultimate change is in a curve. There can evidently 
be no change of points of intersection except by a change in 
at least one of the two curves. Hereafter we shall use the 
phrases " increase of supply " or " increase of demand " 
only in the sense of shifting to the right the supply or demand 
curve; in other words, of increasing the figures of demand 
or supply in the demand or supply schedules. 

When we shift demand or supply curves, the effect on 
the intersection, i.e., on the market price, and the amount 



Sec. 5] SUPPLY AND DEMAND 25 1 

marketed, will, as is evident from the figures, depend greatly 
on the character of the curves ; whether, for instance, one 
or both of them ascend rapidly or slowly. It will be in- 
structive for the student to draw on paper various pairs of 
intersecting curves, making one or both nearly horizontal, 
and again one or both nearly vertical, and to observe the 
various effects then obtained, first, by shifting the demand 
curve a given distance to the right or left, and second, by 
shifting the supply curve a given distance to the right or 
left. 1 In actual fact, demand and supply curves are con- 
stantly shifting, with the result that their point of inter- 
section is constantly shifting, sometimes to the right, 
sometimes to the left, sometimes up and sometimes down. 
Consequently the market price and the amount marketed 
are changing from time to time. 

The causes which shift the curves are innumerable. 
Changes in taste or fashion will affect demand curves, while 
changes in methods of production will affect the supply 
curves. For instance, automobiling increased the demand 
for fur coats, and has, therefore, raised their price ; while 
improved machinery has made it easier to produce shoes 
and has consequently lowered their price. 

As to the variable point of intersection, we are more in- 
terested in its latitude than in its longitude, for the latitude 
represents the market price. This market price will evi- 
dently rise with a rise in either curve, and fall with a fall in 
either curve. It will also rise with a shifting of the demand 
curve to the right, or with a shifting of the supply curve 
to the left ; and will fall with a shifting of the demand curve 
to the left, or of the supply curve to the right. In fact, 
by a leftward change in the demand curve or a rightward 
change in the supply curve, the price may fall to zero. A 

1 Observe that when the demand curve is shifted, the change in price 
involved depends upon the steepness of the supply curve; and, vice versa, 
that when the supply curve is shifted, the change in price involved depends 
upon the steepness of the demand curve. 



252 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



standard example of such a case is furnished by the air we 
breathe, the supply of which is so much more abundant 
than the demand that it bears no price. The same is often 
true of water and of land of inferior qualities. There are 
millions of acres of land which may be had for practically 
nothing (a fact of much importance to be emphasized in 
a future chapter). 

One cause of shifting demand and supply curves men- 
tioned in a general way at the beginning of this chapter we 
wish especially to emphasize. This cause is a change in 
the general purchasing power of money. Let us suppose 
that we change our monetary unit so that what is now fifty 
cents should be called a dollar. This would mean that the 
purchasing power of a dollar had been cut in two, or that 
the level of prices had been doubled. We ought, therefore, 
to find that the demand and supply of sugar will have been 
affected so as to double its price — the latitude of the point 

of intersection — 
and this is, in fact, 
the case. As soon 
as the half-dollar 
becomes a dollar, 
the price in " dol- 
lars " at which 
any given amount 
of sugar, such as 
Ox (in Fig. 26), is 
demanded, will 
evidently be 
doubled, becoming 
xB, which is twice 
xA. If previous- 
ly people were 
willing to take Ox 
at one price, they are now willing to take it at double that 
price, because this double price means in purchasing power 



Y 


















1 




































\ 


































\ 

\ 


































\ 




































\ 
\ 


































\ 


B 




































































s 


\ 


































\ 


v 
































































A 











































































































































































































1 


e 








X 



Fig. 26. 



Sec. 5] 



SUPPLY AND DEMAND 



2 53 



exactly the same thing as the original price. And in fact 
all points in the demand curve will be shifted to be twice 
as high as before. 

In the same way and for the same reasons, those who 
have sugar to sell will require twice as high a price as before 
for a given amount; so that, as indicated in Figure 27, 
each point, such as A, in the supply curve, will be shifted 
to twice as high an elevation above the base, OX. 

When the two curves thus shifted are drawn on the same 
axes (see Fig. 28), it is evident that the new point of inter- 
section, B, will be vertically over the old point of inter- 
section, A. 

The market price of sugar is therefore doubled, though 
the amount marketed is unchanged. Simply the doubling 
of the general 
price level carries 
with it a doubling 
in the price of 
sugar. While the 
supply and de- 
mand curves for 
sugar may change 
for many other 
reasons than the 
doubling in gen- 
eral price level, so 
far as this cause, 
taken by itself, is 
concerned, its ef- 
fect on prices is 
to double them. 
Our analysis of demand and supply curves then brings us 
back to the fact already stated, that the price of any par- 
ticular good, like sugar, depends partly on the general 
level of prices, or the purchasing power of money. 

We can now see more clearly than before the shallowness 



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1 






























/ 






























^t 


y 




























-- 


- 
















































































































































































1 




























O 


















3 


C 










X 



Fig. 27. 



2 54 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



of the idea that the supply and demand of each individual 
commodity fixes its price independently of other com- 
modities. According to this view, the general price level 
is regarded as the effect of innumerable individual pairs of 
supply and demand curves, each pair being supposed to 
completely determine some one price. The opposite is the 
truth. The general price level is not the result of the supply 
and demand of sugar in relation to money, but is itself one 
of the causes affecting the supply and demand of sugar in 

relation to money ; 

y l 1 1 ■ j \ | \ ' for we have seen 

(Figs. 26, 27 and 
28, and discussion) 
that, as the price 
level rises or falls, 
the price of sugar 
rises and falls cor- 
respondingly. 

We end this 
chapter, therefore, 
with the state- 
ment with which 
we began; name- 
ly, that it is im- 
portant to distin- 
guish between the 
influences determining the general price level and the 
influences determining an individual price. The price 
level is determined by a comparatively simple mechanism, 
that of the equation of exchange. It is the result of the 
quantity of money and deposits, the velocities of their cir- 
culation, and the volume of trade. The general price 
level, then, helps to fix individual prices, although not in- 
terfering with relative variations among them, just as the 
general level of the ocean helps fix the level of individual 
waves and troughs without interfering with variations among 




Fig. 28. 



Sec. 5] SUPPLY AND DEMAND 255 

them. The tides determine whether a wave shall be as 
a whole high or low, and so the general level of prices, while 
it does not fully fix the price of sugar, determines whether 
it shall be in general high or low. A rise in the general price 
level is one of the many causes raising the demand and supply 
curves of sugar ; and, reversely, a fall in that level is a cause 
lowering those curves. 



CHAPTER XVI 

THE INFLUENCES BEHIND DEMAND 

§ i. Individual Demand Schedules and Curves 

We have seen that the market price of any particular 
good is that price in the demand and supply schedules which 
will just clear the market. Both market price and quantity 
marketed are determined by the intersection of the supply 
and demand curves. But the supply and demand curves 
are not the ultimate influences determining prices. They 
are only the proximate influences. Beneath and behind 
them lie influences more remote and more fundamental. 
In this chapter we shall consider those remoter influences 
so far as they have to do with the demand side of the 
market. Our problem, therefore, is to analyze the 
demand curve into its ultimate elements. In the preceding 
chapter the demand schedule or curve was considered as 
a cause. In this chapter it is considered as an effect of 
antecedent causes. 

In the first place, the demand schedule or curve is for the 
community as a whole; and this community consists of 
a large number of individuals, each of whom contributes his 
share to the formation of the total demand. In fact, the 
total demand at any price is merely the sum of the individ- 
ual demands at that price. For instance, let the following 
table represent the demand schedules for coal of two in- 
dividuals distinguished as Individual No. I and Individual 
No. II, at prices of from $12 to $2 per ton : — 

256 



Sec. i] THE INFLUENCES BEHIND DEMAND 

Demand Schedules 



2 57 



Price 


No. I 


No. 11 
{b) 


Total 
(a + 6) 


$12 


2.0 


1.0 


3-o 


IO 


2-3 


1.2 


3-5 


8 


2.8 


i-4 


4.2 


6 


34 


1.8 


5-2 


5 


4.0 


2.0 


6.0 


4 


4-7 


2-3 


7.0 


3 


5-7 


2.8 


8-5 


2 


7.0 


3-2 


10.2 



The table tells us that at a price of $12 a ton Individual No. 
I will take only two tons, and Individual No. II will take 
only one ton ; that at a price of $6 a ton Individual No. I 
will take 3.4 tons, and Individual No. II will take 1.8 tons ; 
and so on. 

The last column gives the sum of the demands of these 
two individuals. If we should extend such a table to in- 
clude the de- 
mands of all the 
individuals in the 
community, we 
would obtain the 
total demand in 
the community. 
The total demand 
schedule is thus 
found to be 
merely the sum 
of the individual 

demand schedules O • a 3 4 5 6 7 8 9 10 11 12 13 w j 
found by adding FlG - 2 9- 

together all the individual amounts demanded at any given 
price. Behind the total demand schedule, therefore, are a 
number of constituent demand schedules, 
s 




258 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XVI 



The same relation, of course, holds between total and 
individual demand curves. In Figure 29 let the curve did x ' 
represent the demand curve for Individual No. I, and d^' 
the demand curve for Individual No. II. At a given 
price, Oy, the demands of these two individuals are re- 
spectively ydi and yd 2 . The sum of these two demands 

Thus we add the longitudes of 
the two individual demand 



is represented by yD 
"Yl 




Fig. 30. 



curves together to get the 
longitude of the combined 
curve DD f . If, instead of 
two individual demand 
curves, we should have all 
the demand curves for all the 
individuals in the market, 
and should add together, as 
already indicated, the longi- 
tudes corresponding to given 
latitudes, i.e., the demands 
corresponding to given 
prices, we should thereby obtain the total demand curve 
as pictured in the previous chapter. 

We may pause here to note the fact that, ordinarily, any 
one individual plays so small a part in the demand for any 
commodity that he regards the price as beyond the influence 
of any act of his. He finds this price ready made in the 
market and adjusts his demand to it. To him the price is 
a fixed fact and entirely beyond his control, while his de- 
mand, the quantity he chooses to take at that price, is 
the only thing which he can adjust. It is of course true 
that each individual, however insignificant his demand, 
has theoretically an influence upon the general price, but 
the influence is so small as to be practically negligible. While 
for the market as a whole price is effect and not cause, yet 
for the individual it is cause rather than effect. 

To see more clearly these relations to the individual and 



Sec. 2] THE INFLUENCES BEHIND DEMAND 259 

to the total, we have drawn in Figure 30 an individual 
demand curve dd' , the total demand curve DD' , and the 
total supply curve SS' . The intersection of the last two 
determines the market price P X' (or OP', or px) ; and this 
price determines for the individual the amount, P'p (or Ox), 
which he will take at that price. 

§ 2. Marginal Desirability 

We have now found that back of the demand curve or 
schedule in any market lie the individual demand curves 
or schedules of all the people who compose that market. 
The next step is to find what causes He back of the indi- 
vidual demand curves or schedules. Taking, for instance, 
the demand curve of Individual No. I, we may ask : What 
are the conditions which determine its shape and size? 
The answer is that it depends upon the desires of Individual 
No. I. It is true that a man may have a strong desire for 
something without having any demand for it in the economic 
sense. But this is simply because he desires still more the 
money he would have to spend for it. Every purchaser of 
goods balances two desires, the desire for the goods and the 
desire for the money they would cost. On the relative 
strength of these desires depends the price he is willing to 
pay. We have, therefore, to investigate these two desires, 
the one for goods, the other for money. We shall begin 
with the desire for the goods. 

Desire for goods implies desirability in those goods. The 
term " desirability " is synonymous with what is usually 
called " utility " in textbooks. " Desirability " is preferred 
here as a better term to express the idea intended. If there 
exists a keen desire to purchase a certain piece of land, we 
say that the land is especially desirable or has great desir- 
ability. Likewise precious stones have great desirability 
to many people. Tobacco has great desirability to a smoker ; 
silks and satins to ladies of fashion ; books to scholars ; and 



260 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

so on. The concept "desirability" is so important that it 
ought to be denned with great care. The desirability of 
any particular goods, at any particular time, to any partic- 
ular individual, under any particular conditions, is the 
strength or intensity of his desire for those goods at that time 
and under those conditions. The desirability of any goods is 
one of the most important factors in determining its price. 

The connection, however, between desirability and price 
was for a long time overlooked because of the puzzling fact 
that many of the most desirable articles are the cheapest, and 
many of the least desirable are the dearest. Thus water is 
so desirable as to be indispensable, yet there are few things 
which are cheaper. On the other hand, jewelry, which could 
easily be dispensed with entirely, bears high prices. This 
paradox, however, is easily explained. While it is true that 
water as a whole is very desirable, any particular quart of 
water has usually very little desirability. It could easily 
be dispensed with because there are so many other quarts 
which could take its place. Were any particular quart 
of water indispensable, it would bear a high price. On the 
other hand, while all the jewels of the world could be more 
easily dispensed with than water, yet any particular jewel 
is more desired than any particular quart of water. It is 
the desirability of any particular unit of water or of jewelry 
which influences its price and not the desirability of all the 
water in the world taken together or all the jewelry. 

The desirability of any particular good may thus relate to 
the whole or to any part of a quantity of that good. The 
desirability of the entire quantity is called the total desira- 
bility ; the desirability of one unit more or less than a cer- 
tain given number of units of that quantity is called the 
marginal desirability. In economic science we have to do 
with marginal more than with total desirability, and it is 
therefore important that the concept of marginal desira- 
bility should be thoroughly understood. A new light was 
shed on the theory of prices when, forty years ago, three 



Sec. 2] THE INFLUENCES BEHIND DEMAND 261 

economists independently of one another — Jevons in 
England, Menger in Austria, and Walras in Switzerland — 
distinguished marginal from total desirability and showed 
how marginal desirability can be used to explain many of 
the mysteries of prices. 

The marginal desirability of any good is the desirability of 
one unit more or less of it. 

To illustrate in detail the distinction between total and 
marginal desirability, let us suppose a person wishing to 
furnish his house with chairs. As presumably he does not 
wish to sit or compel his friends to sit on the floor, it is 
desirable that he should have some chairs ; but each succes- 
sive chair that he introduces will lessen the need for more. 
One chair is so highly desirable as to be almost indispen- 
sable. It provides a seat for at least one person. A second 
chair, though not quite so indispensable as the first, is also 
extremely desirable, as it is likely that he will often wish 
seating capacity for at least two. A third chair, though 
less urgently needed than the second, will be highly desir- 
able ; and so on — each successive chair having a lower 
desirability than the preceding. The number of chairs 
which he will buy will depend, among other things, upon 
their price. To fix our ideas, let us suppose that he decides 
to buy ten. Whatever the quantity chosen, the last chair 
is called the marginal chair, and its desirability is called 
the marginal desirability. It is this last or marginal chair 
which gives him the most concern when he attempts to 
decide how many to buy. He has no difficulty, for instance, 
in deciding that he does not want thirty or forty chairs ; the 
question which requires careful consideration in his mind 
is whether he shall stop buying at the tenth chair or at a 
slightly earlier or later point. He will consider carefully 
what difference it will make whether he has nine chairs or 
ten, or what difference it will make whether he has ten or 
eleven. If he decides on ten rather than nine, it is because 
he thinks the tenth chair will make enough difference to him 



262 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

to be worth the price he pays, and if he decides against the 
eleventh chair, it will be because he thinks this will not make 
enough difference to compensate him for the price. For 
instance, we may suppose" that the price of the chairs is 
$10 each. If so, the fact that he decides to take the 
tenth chair shows that this tenth chair has at least $10 
worth of desirability, while the fact that he decides 
against the eleventh chair shows that this eleventh chair 
does not have as much as $>io worth of desirability. Prac- 
tically money is used in just this way to measure the com- 
parative desirabilities of various goods. The last or tenth 
chair bought is called the marginal chair of the ten, and the 
desirability of this last or tenth chair is called the marginal 
desirability of the ten chairs. 

The total desirability, on the other hand, of the ten chairs 
is evidently quite another matter. This is the sum of the 
desirabilities of the first chair, second, third, etc., considered, 
as above, in succession up to the tenth. The householder 
will not ordinarily be as definitely aware of total desirability 
as he is of marginal desirability. As we have seen, he will, 
in order to decide how many chairs to buy, have to give 
careful attention to the desirability of the tenth chair ; it is 
so easy to decide upon the first few chairs that he will not 
ordinarily stop to reckon exactly how desirable the ten chairs 
as a whole may be. Should he wish to reckon this desira- 
bility, he would do so by thinking how much difference it 
makes to him whether he has ten chairs or none at all. For 
instance, he might think that to have ten chairs rather 
than none at all is worth about $150 to him. Then $150 
would measure the total desirability of the ten chairs, while 
the marginal desirability, that is, the desirability of the last 
or tenth chair, is only about $10. From what has been said 
it will be evident that the total desirability is of only theo- 
retical importance, while marginal desirability is of great 
practical importance. It is of little practical importance to 
any purchaser to know how much is the total desirability of 



Sec. 2) THE INFLUENCES BEHIND DEMAND 263 

the chairs he owns ; namely, how great is the difference in 
comfort and convenience between having the number of 
chairs which he actually does have and having none at all. 
He finds it difficult to imagine how it would seem to have 
none at all. Such a condition can be considered only hypo- 
thetically. It never enters into his calculations as a practi- 
cal possibility. 

. On the other hand, marginal desirability enters daily 
into practical life. The question which every purchaser of 
goods asks himself is where to stop — where to draw the line 
or margin beyond which he will not buy. He has to fix a 
margin in every purchase, and in fixing it he has to settle 
the question whether one unit more or less is or is not as 
desirable as the money which he will have to pay for it. 
In other words, with the desirability of this unit he has to 
compare the desirability of the money which it will cost. 
He can only solve the question of how much to buy by 
weighing carefully in his mind the desirability of the last 
few units. 

The total quantity of goods whose marginal desirability 
is under consideration may be any specified quantity of 
goods whatever. It may be a specified quantity of goods 
now existing, or a specified quantity of goods in the future, 
or a specified flow of goods through a period of time. For 
instance, by the marginal desirability of coal to an individ- 
ual may be meant the marginal desirability of the particular 
stock of coal in his bin at the present moment. If this stock 
consists of fifteen tons, its marginal desirability is the 
desirability of the fifteenth ton, or the difference to him 
between the desirability of having fifteen and of having 
fourteen tons. Again, if a person is consuming in his house- 
hold fifteen tons of coal a year, its marginal desirability 
at any time is the desirability of the fifteenth ton, or the 
sacrifice which, in his estimation at that time, would be 
occasioned were he to reduce his yearly consumption from 
fifteen tons to fourteen. A stock of fifteen tons and a con- 



264 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVI 

sumption of fifteen tons a year are evidently quite distinct. 
It is therefore necessary in each case to specify the particular 
quantity of goods referred to, whether it be a stock in the 
present or a stock in the future or a flow through a period 
of time. 

Undesirability is the opposite of desirability. Often we 
may express the same fact in terms of either word. For 
instance, it does not matter whether we speak of the 
desirability of keeping money, or the undesirability of 
losing it. 

The first principle in regard to marginal desirability is 
that an increase in the quantity of goods, whose marginal 
desirability is under consideration, results in a decrease in 
the marginal desirability. This we have noted in the case 
of the chairs. Each unit in addition is less desirable than 
the preceding unit. 

Marginal desirability is, as we have seen, often expressed 
as the desirability of the " last " unit. But it is important 
to note that by the "last" unit — say, the tenth chair 
— is not meant any particular chair of the ten, but 
merely the difference between having nine chairs and ten 
chairs. 

A particular and important instance of marginal desira- 
bility is the marginal desirability of money. The marginal 
desirability of money at any particular time, to any par- 
ticular individual, under any particular conditions, has the 
same sort of meaning as the marginal desirability of any 
other good. It means, therefore, the strength or intensity 
of a man's desire for an additional dollar, or, what amounts 
to the same thing, his reluctance to part with it. Briefly, 
the marginal desirability of money to him is the desira- 
bility of a dollar to him. Whenever he thinks of making 
a purchase, this desire comes into play, and the question 
of whether or not to buy is, as implied in the preceding 
discussion, determined by his judgment as to whether or 
not the marginal desirability of the goods exceeds the mar- 



Sec. 3] THE INFLUENCES BEHIND DEMAND 265 

ginal desirability of money multiplied by the price in money 
required to secure those goods. 

§ 3. Individual Demands Derived from Marginal De- 
sirabilities 

It is on such comparison of the marginal desirabilities 
of goods and money that the demand curve of each individ- 
ual depends. We shall now illustrate in detail how demand 
depends on desirability by taking the desires and demand 
of a given individual (whom we shall call No. I) for a given 
good (such as coal) . We are to show that the price Individ- 
ual No. I is willing to pay is simply the ratio between two 
marginal desirabilities, that of coal and that of money. 

If he thinks that one ton of coal is a dozen times as 
desirable to him as a dollar, he will evidently be willing to 
pay any price up to $12 for that ton. If the price is over 
$12, he will not buy even a ton of coal. If it is just $12, 
he is willing to buy just one ton. A second ton will be worth 
less, in his estimation, being, let us say, only ten times as 
desirable as a dollar. He will then be willing to pay up to 
$10 for this second ton. If, then, the price is $10, he will 
buy up to two tons ; for at that price it will evidently be 
more than worth his while to buy the first ton and just 
worth his while to buy the second. If the desirability of a 
third ton is eight times the desirability of a dollar, he will 
be willing to pay up to $8 per ton for three tons ; for at 
that price the first and second tons are more desirable than 
the money, and the third, just as desirable. If the desira- 
bility of the fourth ton is six times that of a dollar, he is 
willing to pay a price up to $6 per ton for four tons. 

In each case the highest price he is willing to pay for a given 
quantity is measured by the ratio of the desirability of the last 
ton to the desirability of a dollar. The consequent deriva- 
tion of prices from desirabilities is summarized in the fol- 
lowing table : — 



266 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 





Desirability of 


Desirability of 


Price the Cus- 


Tons Purchased 


Last Ton 
Purchased 


a Dollar 


tomer WOULD BE 
WILLING to Pay 




(a) 


(.b) 


(a-f-i) 


I 


12 




$12 


2 


IO 




IO 


3 


8 




8 


4 


6 




6 


5 


5 




5 


6 


4 




4 



As indicated, the last column is found by taking the ratio 
of the figures in the second to those in the third ; that is, 
dividing (a) by (b). As there are no standard units of 
desirability, it will not matter what unit we select. In the 
table, for simplicity of division, we have taken as our unit 
for measuring desirability the marginal desirability of money 
to Individual No. I himself. We thus derive the individ- 
ual's demand schedule from his schedule of desirabilities. 
The resulting demand schedule is the fourth column con- 
sidered with respect to the first column. It tells us the 
highest prices (column 4) Individual No. I is willing to 
pay for stated quantities of coal (column 1), or, what 
amounts to the same thing, the largest quantities of coal 
he is willing to take at stated prices. As shown in the 
preceding chapter, it does not matter which way the rela- 
tion is expressed. 

In the preceding table the numbers expressing desirabil- 
ities of coal and those expressing price are the same, be- 
cause we took the marginal desirability of money as our unit 
of desirability. In this case we may say that the marginal 
desirability of any point in the table is measured numeri- 
cally by the money the individual is willing to pay for the 
marginal unit at that point. But suppose another individual 
(No. II) who has precisely the same intensities of desire 
as No. I for coal, but who, on account of relative poverty, 



Sec. 3] 



THE INFLUENCES BEHLND DEMAND 



267 



prizes each dollar twice as much as does Individual No I. 
In comparing the two men, we shall have to use the same 
unit of desirability, viz., the marginal desirability of money 
to Individual No. I. For Individual No. II the desira- 
bility of money is therefore two such units. The result 
is the following table for Individual No. II : — 



Tons Purchased 


Desirability of 
Each Successive 


Desirability of 
a Dollar 


Price the Cus- 
tomer WOULD BE 




Ton 




WILLING to Pay 




w 


(b) 


(« + J) 


1 


12 


2 


$6 


2 


IO 


2 


5 


3 


8 


2 


4 


4 


6 


2 


3 


5 


5 


2 


2.50 


6 


4 


2 


2 



The first ton has a desirability of 12 units just as did the 
first ton for Individual No I, but the desirability of a dollar 
to Individual No. II is twice as great as the desirability of a 
dollar to Individual No I, i.e., it has two units of No. I's de- 
sirability. Hence the first ton, instead of being twelve 
times as desirable as a dollar, is only six times as desirable. 
Therefore he is willing to pay only up to $6 for it. Just as in 
the case of Individual No. I, the prices in the last column are 
found by dividing the figures in the second column by those 
in the third. But in this case the figures in the last column 
are not identical with those in the second column, but are 
only half as great. And in general the higher the marginal 
desirability of money, the lower the schedule of prices which 
buyers are willing to give. 

We see, then, that the two individuals, though they have 
precisely the same desires for coal, have very different 
demands for coal. If the price of coal is $5 a ton. Indi- 
vidual No. I will buy up to the fifth ton ; for when he reaches 



268 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVI 



the fifth ton, and not before, the marginal desirability of 
coal (5) to him will be just five times that of a dollar (1). 
But at this same price of $5, Individual No. II will only buy 
up to two tons ; for in his case $5 is the point at which the 
marginal desirability of coal (10) is five times the marginal 
desirability of a dollar (2). This contrast interprets the 
fact that the poor " cannot afford " to buy as much as the 
rich. The poor, like Individual No. II, have a relatively 
high marginal desirability of money. 

It is easy to express these same relations by curves. The 
demand curve is, as we know, merely a graphic picture 
of a demand schedule. We may likewise draw desirability 
curves as graphic pictures of desirability schedules. And 
just as the demand schedule is derived by simple division 
from desirability schedules, so is the demand curve derived 
by simple division from desirability curves. 

In Figure 31 the curve dd' is the desirability curve of coal 
for Individual No. I ; that is, it represents the desirability to 

him of each successive ton 
of coal as given in the pre- 
ceding table. Thus the 
latitude or height (12) of 
d represents the desirability 
of the first ton. The 
height (10) of the next 
d . point to the right repre- 
sents the desirability of the 
second ton ; and so on to 
d! ', the height of which (5) 
" m ' represents the desirability 
~X of the fifth ton. The desir- 
F IG . 3I< ability of the fifth ton is 

called the " marginal desir- 
ability " of five tons, the desirability of the fourth, the 
marginal desirability of four tons, etc. The latitude or 
height of each of the points from d to d' represents the 



ck 



12 



'V 



Sec. 3] 



THE INFLUENCES BEHIND DEMAND 



269 



marginal desirability of the amount of coal corresponding 
to the longitude of that point. The heights of the 
points which form a horizontal row one unit above 
the base represent the marginal desirability of money. 
From the heights of these two sets of points — the upper ones 
representing the marginal desirability of coal and the lower 
ones representing the marginal desirability of money — 
by simple division of the numbers indicated, we derive the 
heights of the set of points constituting the demand curve 
for Individual No. I. As the divisor is in this case unity, 
the demand curve so derived will coincide with the curve 
dd' . Hence dd' will serve not only as the desirability curve 
for coal for Individual No. I, but also as the demand 
curve for Individual No. I. 

Figure 32 represents the corresponding curves for In- 
dividual No. II, for whom, by hypothesis, there are precisely 
the same marginal desira- 
bilities of coal, but for Y 
whom the marginal desira- 
bility of money is twice as 
great. The upper points, r 
to r, represent the marginal 
desirability of coal, and are 
at the same heights as the 
upper points d to d' in 
Figure 31. The lower 
points in Figure 32, how- 
ever, are now two units high 

instead of one. Hence, 0] i 2 3 a 5 x 
when we divide the num- Fig. 32. 

bers 12, etc., for rr' by the 

number 2, we shall get as our demand curve a curve dd' , 
which, unlike the demand curve for Individual No. I, will 
not coincide with rr, but will be everywhere only half as 
high. 

We see, then, how to derive an individual demand schedule 



5~^ 



3"~---d' 



270 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

(or curve) by dividing, so to speak, one desirability schedule 
(or curve) by another. The resulting demand schedule (or 
curve) of coal will coincide with the schedule (or curve) 
of marginal desirability of coal if the marginal desirability 
of money be taken as unity. Otherwise the demand 
schedule (or curve) will have its figures all standing in a 
given ratio to those of the schedule (or curve) of marginal 
desirability of coal. In either case the demand curve is, 
or is equal to, a desirability curve translated into terms of 
money. 

This is all true on the assumption that the marginal 
desirability of money for each individual remains constant, 
as represented in our tables or curves, being always unity for 
Individual No. I and always 2 for Individual No. II. In 
other words, we have assumed that the marginal desirability 
of money is not appreciably affected by a large or small pur- 
chase of coal. Of course, a purchase might be made so large 
or at so high a price that the marginal desirability of money 
would be appreciably affected. Theoretically, the marginal 
desirability of money increases with every expenditure; 
the less money there is left, the more precious it becomes. 
But there are so many ways to spend money, and the ex- 
penditure on any one thing, such as coal, requires so small 
a drain on the total power to spend, that the marginal de- 
sirability of money is not very different whether a man buys 
no coal at all or all the coal he can afford. Consequently 
for the same individual, the desirability of a dollar may be 
regarded as practically a constant quantity represented, as 
in Figures 31 and 32, by the heights of a horizontal row of 
points. 

In the last chapter we considered the price of coal as the 
effect of supply and demand and expressed by two curves. 
In this chapter we have seen that one of these two curves, the 
demand curve, is in turn the effect of innumerable individ- 
ual demand curves; and, finally, that each of these indi- 
vidual demand curves is in turn the effect of two desirability 



Sec. 4] THE INFLUENCES BEHIND DEMAND 27 1 

curves — one for coal and another for money — which charac- 
terize the given individual. These desirability curves are 
the ultimate curves lying back of demand, and the demand 
curve is or is equal to a desirability curve translated into 
terms of money. 

§ 4. Relation of Market Price to Desirability 

We are now ready to see clearly that the market price 
of coal, although it is itself the ratio between two physical 
things — the ratio of a quantity of money to a quantity of 
coal — is, nevertheless, equal to the ratio between two in- 
tensities of desire in the mind of each purchaser — the ratio 
of the marginal desirability of coal to that of money. No 
individual demander of coal can, of course, determine the 
market price of coal. On the contrary, to him the market 
price seems to be fixed, and all that he can do is to adjust 
his purchase to it. But this adjustment, when practiced 
by all the numerous persons who demand coal, constitutes 
the whole demand side of the market, and exerts, therefore, 
a very powerful influence on said existing market price. 
Market price, we have seen, must " clear the market," and, 
applied to the demand side of the market, this means that 
the market price must be such that when each individual 
on the demand side adjusts his purchase to it in such a 
manner that the ratio of his marginal desirability of coal to 
his marginal desirability of money is equal to the price, the 
sum total of all such purchases (i.e., the total demand) shall 
equal the total supply. 

This principle that the market price of any good is equal to 
the ratio between its marginal desirability and the marginal 
desirability of money is so important that it will be advisable 
to restate it in as many forms as possible. 

Any one of the following statements will show where the 
stopping point of each purchaser is : — 

1. Each purchaser buys until the ratio between the 



272 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

desirability of the marginal unit and the marginal desira- 
bility of the dollar is reduced to equality with the price. 

2. Each purchaser buys until the desirability of the 
marginal unit is reduced to equality with the desirability of 
the money spent for it. 

3. Each purchaser buys until his marginal gain (of de- 
sirability) is reduced to nothing. 

4. Each purchaser buys until he makes his gain (or surplus 
desirability) a maximum. 

The last two may require further explanation. 

Evidently it is the same thing to say that a purchaser 
stops buying when the desirability of the last ton is equal 
to the desirability of the money paid for it, as to say that 
he stops buying when the last ton has no excess of desirability 
over the desirability of the money paid for it. 

Let us examine the nature of the gain which the pur- 
chaser makes, and which is thus reduced to zero on the last 
ton. Evidently he gains no money; on the contrary, he 
loses it. What he does gain is desirability. His gain in 
desirability or his surplus desirability is the difference be- 
tween the total desirability of the coal he buys and the total 
desirability of the money he has to sacrifice. 

If the price is $5 per ton, in which case Individual No. I, 
as his schedule (or curve) shows, buys 5 tons, the total de- 
sirability of these 5 tons to him is 41 units of desirability, 
being the sum of the desirabilities as given in the schedule 
(or curve) for these 5 consecutive tons, viz., 12 + 10 + 8 + 
6 + 5, or 41 ; the sacrificed desirability is the desirability 
of the $25 spent, which, as we assume that each dollar has 
1 unit of desirability, is 25 units ; the surplus desirability is 
the excess of the total over the sacrificed desirability, or 
41 — 25 = 16 units. 

Now this gain of 16 consists "of diminishing gains on suc- 
cessive tons. On the first ton the gain is the difference be- 
tween the 12 units which the ton is worth and the 5 units 
he must sacrifice to get it ; this is 1 2 — 5, or 7 units. Likewise 



Sec. 4] THE INFLUENCES BEHIND DEMAND 273 

the gain on the second ton is 10 — 5, or 5 units ; on the third, 
S — 5, or 3 units ; on the fourth, 6 — 5, or 1 unit ; and on the 
fifth, 5 — 5, or zero. He stops his purchase at this point, 
for, if he should extend it further, he would lose desirability. 
The sixth ton, for instance, would yield only 4 units and 
cost him 5, and the seventh and later tons would cause 
greater losses. 

Likewise for Individual No. II, who can only afford to buy 
2 tons, the total desirability is 12+10, or 22 units; the 
sacrificed desirability is the desirability of the $10 paid, 
which, as each dollar is supposed to have 2 units of de- 
sirability, is 20 units ; and the surplus desirability is 22 — 20, 
or 2 units. This gain is all on the first ton, as the second is 
worth only its cost. 

Individual No. I thus gains more than Individual No. II, 
though both gain something. 

The last method of stating the principle was that each 
buys so as to make the greatest possible gain of desirability. 
Evidently, Individual No. I gets his greatest gain by buying 
5 tons. His gains on these 5 tons were, respectively, 7,5,3, 1, 
and o units, making, as we have seen, an aggregate gain of 
16 units. Had he stopped buying at the third ton, his gain 
would have been one unit less, or 15 units. On the other 
hand, if he had bought 6 tons, he would have lost one unit on 
the sixth ton, which would have reduced his gain from 16 
to 15. Thus by stopping at the fifth ton he gains the 
most he can. 

The idea of something, not money, gained in a trade is 
important to grasp. By its aid we have no difficulty in 
understanding that both parties normally gain by a trade. 
Trade does not imply that one of the two parties gains at 
the expense of the other. This is true when one of the two 
parties cheats the other, but normal trade is not cheating. 
Nevertheless, the idea that only one party can gain by a 
trade is an old and persistent one. It was largely responsible 
for attempts to regulate prices in the Middle Ages, to make 



274 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

the price " just " and prevent one party gaining at the ex- 
pense of the other ; it was also largely responsible for the 
sentiment in favor of encouraging the export trade and dis- 
couraging the import trade, — a practice which implied that 
a nation was winning when it sold more than it bought, 
but losing when it bought more than it sold. In fact, the 
phrases " favorable balance of trade " and " unfavorable 
balance of trade," based on this idea, are still in use, al- 
though their original implication of gain or loss is gone. 
We now recognize that the country parting with money by 
buying goods from abroad may gain desirability just as 
the man who parts with money by buying coal gains 
desirability. 

§ 5. Importance of the Marginal Desirability of Money 

The student will have noticed that the money element 
was present in all the stages of our study, and is still present 
even when we carry our analysis down to each individual 
mind. A halving of the purchasing power of money halves 
its marginal desirability to each person. But as we have 
seen in the desirability schedules (and curves) of Individuals 
I and II, the marginal desirability of money to the indi- 
vidual is a divisor to be divided into the marginal desira- 
bility of coal to him in order to give the price the individual 
is willing to pay for coal. Therefore, to halve this divisor 
for each individual will result in doubling the quotient — 
the price he is willing to pay. In other words, the prices 
in each individual's demand schedule (or curve) will all be 
doubled by halving the purchasing power of money. Con- 
sequently the same is true of the total demand schedule 
(or curve). This is merely restating what has been said 
before, except that before we considered the demand as a 
whole, whereas now we trace back the effects of a change 
in the purchasing power of money to each individual on 
the demand side of the market. 



Sec. 5] THE INFLUENCES BEHIND DEMAND 275 

We can now see more clearly than in Chapter I how care- 
ful we should be when measuring values in terms of money. 
If our object is to compare desirabilities, we must correct 
our money comparisons for differences in the desirability of 
money. We must make allowance for differences in the 
importance of a dollar (1) among different people according 
to differences in wealth and needs, and (2) between different 
times or countries according to differences in purchasing 
power of money. 

(1) If a millionaire's wife pays $10,000 for a brooch, while 
her poor neighbor pays $10 for a gown, we should not infer 
that the rich woman prizes her brooch a thousand times as 
much as the poor woman prizes her gown. This would 
be true if the desirability of a dollar were the same in the 
two cases, but as it is likely that the poorer woman prizes 
a dollar more than a thousand times as highly as does the 
richer woman, it is altogether probable that the gown is of 
more importance to the poor woman than the brooch is to 
the rich one, in spite of the fact that in money the brooch is 
worth a thousand times the gown. 

From the fact that the richer an individual is, the less the 
marginal desirability of money to him or her, it further 
follows that the difference in desirability of two fortunes is 
much less than their money values would suggest. A man 
whose income has increased from $1000 to $10,000 a year 
is better off than when it was $1000 a year, but he is not ten 
times better off. The extra $9000 may not be worth as 
much as the original $1000, in which case he is not even 
twice as well off. It is still truer that a man with a fortune 
of $500,000,000 is only slightly better off (if at all) than one 
with only $1,000,000. Were these facts better appreciated, 
" great riches," though desirable, would be less dazzling to 
those who have never possessed them. 

In Figure 33, longitude represents the income of a man, 
and latitude represents its marginal desirability to him. 
The curve is purely illustrative, as we do not know in 



276 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVI 



figures what exact difference in the marginal desirability of 
money is caused by a given increase in a man's income. It 
is intended merely to express the fact that the marginal 
desirability of money (assuming a given purchasing power) 
decreases very rapidly with an increase in income ; that is, 
the richer a person, the less — and very much less — he 

prizes an individ- 
ual dollar. The 
curve probably 
continues to the 
right indefinitely, 
though approach- 
ing closer and 
closer to the base ; 
no matter how 
rich a man be- 
comes, an addi- 
tional dollar will 
still have some 
desirability in his 
eyes. Man is 
FlG- 33- literally insatiable. 

(2) So much for the allowance to be made between dif- 
ferent individuals. As to the allowance to be made for 
differences in different price levels, we note that money 
wages in the United States are higher, for instance, than 
money wages in England ; but that it is misleading to make 
any comparisons unless we first correct for differences in the 
price levels or purchasing power. In some occupations it 
would seem that the difference in wages only just corresponds 
to the difference in the purchasing power of money, so that 
in those cases the American workman is really no better off 
than the English. He has more money in wages, but its mar- 
ginal desirability is so much less that he has no more desir- 
able food, lodging, or comforts. In general, however, it is a 
fact that, after all allowances are made for difference in price 



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Sec. 5] THE INFLUENCES BEHIND DEMAND 277 

levels, the lot of the American workman is better than 
that of the English. 

Desirability is, therefore, a far more fundamental concept 
than the concept of mere money value. This could not fail 
to be recognized if we had any practical means of measuring 
desirability. Unfortunately, as yet, we have no such means. 
As money values are usually measurable, we are generally 
compelled to make our measurements in money or else to 
make none at all. This must not, however, mislead us into 
attributing to money measures any greater significance than 
they actually possess. 



CHAPTER XVII 



THE INFLUENCES BEHIND SUPPLY 

§ i. Analogies between Supply and Demand 

In the last chapter we have seen that a total demand 
schedule (or curve) for any particular good is derived from 
innumerable individual demand schedules (or curves), and 
that each individual demand schedule (or curve) is derived 
from a pair of desirability schedules (or curves), one relating 
to the marginal desirability of the particular good under 
consideration and the other relating to the marginal desir- 
ability of money. 

With certain exceptions to be explained later, precisely 
these same propositions are true of the supply side of the 
market. 

First of all, then, the total supply at any price is merely 
the sum of the individual supplies at that price, as illus- 
trated in the following " supply schedules " for coal for two 
individuals. As before, we distinguish them as Individual 
No. I and Individual No. II (without meaning to imply, of 
course, that they are the same individuals as those called 
No. I and No. II in Chapter XVI). 





Supply Schedules. Tons which 
would be supplied by individuals 


Total 
(a+b) 


Price 


I 

(a) 


II 

(b) 


$4 
S 
6 

7 


1 SCO 
1600 
1800 

2 ICO 


2000 

2400 
3000 

3900 


3 SCO 
4000 
4800 
6000 



278 



Sec. i] 



THE INFLUENCES BEHIND SUPPLY 



279 



The table tells us that at a price of $4 a ton, Individual 
No. I will supply only 1500 tons and Individual No. II, 
2000 tons ; that at $5 a ton Individual No. I will supply 
1600 tons and Individual No. II, 2400 tons; and so on. 
The last column gives the sum of the figures in the two pre- 
ceding columns. If we should include in our table all 
supplies in the market, we should obtain in this way the 
total supply schedule. 

The same relations are indicated graphically in Figure 34, 
where Stfi is the supply curve for coal of Individual No. I, 
i.e., a curve such that if the latitude of any point on it 
represents a given price, the longitude of that point will 
represent the amount of coal the individual is willing to 
supply at that 
price. Similarly, 
let szs<>' be the 
supply curve for 
coal of Individual 
No. II. If, as in 
the case of demand 
curves, we add 
longitudes {e.g., 
Sy = s x y + s 2 y), we 
obtain SS' as the 
curve representing 
the total supply of 
both individuals. 

If, in like man- 
ner, we add to- 
gether all the 

individual curves of all the individuals in the market that 
obtain the total supply curve of the market. 

Having thus derived the total supply schedule (or curve) 
from its constituent individual supply schedules (or curves), 
we next seek, as in the case of demand schedules (or curves) , 
to derive each individual schedule (or curve) from a pair of 



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280 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

desirability schedules (or curves). Now the buyer desires 
coal, and the seller desires money. The seller is really a buyer 
of money. Nevertheless, we are not about to construct 
schedules and curves of the desirability of money. It is 
a supply curve we are seeking, and hence it is upon the coal, 
and not the money, that we must keep our attention ; and 
the quality as applied to coal in the mind of the seller is 
not desirability, but ^desirability ; not the undesirability 
of the coal, but the undesirability of the trouble and ex- 
pense of supplying it. Marginal undesirability is also 
called marginal cost. 

The following table illustrates the derivation of the seller's 
undesirability curve or marginal cost curve. The figures 
in the last column, found from the second and third by 
simple division, give the prices a coal dealer would be willing 
to take in view of the undesirability of the trouble and ex- 
pense involved in providing coal and the desirability to 
him of the money he seeks to get by selling coal. If the 
1500th ton costs him 8 units of undesirability, and a dollar 
represents to him 2 units of desirability, he will evidently 
be willing to take $4 a ton up to the 1500th ton ; and so on 
for the other figures in the table. 



Tons Sold 


Undesirability of 

supplying Last 

Ton 


Desirability of 
a Dollar 

(b) 


Price the Dealer 
would be willing 

to Take 

(a + b) 


1500 
1600 
1800 
2100 


8 
10 
12 
14 


2 
2 
2 
2 


$4 
5 
6 

7 



The same relations may, of course, be represented graph- 
ically. In Figure 35, the latitudes of the points on the 
line rr f represent the undesirability per ton of parting with 



Sec. 2] 



THE INFLUENCES BEHIND SUPPLY 



28l 



the coal, and those of the lower line mm f represent the 
desirability per dollar of obtaining the money. The result 
of dividing the latitudes of r - 

the points of rr' by those of Y 
mm {i.e., by 2) gives us the 
supply curve ss', the height 
of which at different points 
will be proportional to the 
height of corresponding 
points of the curve rr'. 
The latitude of the curve 
rr t represents the undesir- 
ability of the efforts and 
sacrifices of furnishing each 
successive unit, or " margi- 
nal undesirability," and the latitude of the curve ss f repre- 
sents this marginal undesirability translated into money. 
This marginal undesirability translated into money is usu- 
ally referred to briefly as marginal cost of production or 
simply as marginal cost. It comprises everything unde- 
sirable involved in supplying the article under consideration, 
including all discounted future costs, the money equivalent 
of all labor and trouble, as well as all actual money ex- 
penses. The seller is more apt to think and talk in terms 
of money than the buyer, for the seller as such has more 
to do with money. Unless he is a mere workman, the only 
cost to whom is labor cost, most of his costs are in the 
form of money expenses. 



Fig. 35- 



§ 2. Principle of Marginal Cost 

Hitherto we have treated the marginal desirability curve 
for money as a horizontal straight line. This was essen- 
tially true for the purchaser, but for the seller it is untrue. 
For the purchaser, money performs many offices besides 
buying coal, and its importance for the purchase of coal is 



282 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 



not great. As to the coal dealer, however, coal is the only 
thing he sells for money. To him, therefore, changes in 
the amount of coal sold and in the price of coal will make 
a great difference in the total amount of money he gets, 
and therefore in its marginal desirability. If, for instance, 
the price of coal changes a dollar a ton, though to the pur- 
chaser this fact will not appreciably affect the marginal 
desirability of money, to the seller it may make all the 
difference between poverty and affluence. 

Consequently, in treating supply, we cannot continue to 
assume that the marginal desirability of money remains 
constant and may be represented by a horizontal straight 
line. Instead, the greater the sales, and the more money 

consequently ob- 
tained, the less will be 
the marginal desira- 
bility of money. 
Therefore, the line 
mm', representing the 
marginal desirability 
of money, should 
descend to the right 
as the sales increase. 
Moreover, the descent 
of this curve, mm', 
will depend on the 
price, so that we can- 
not even construct it until we specify a particular price. 
In Figure 36, these facts are taken into account. In 
this diagram, Oy represents the assumed price; the 
curve rr', as before,- represents marginal undesirability of 
furnishing coal ; and the descending curve mm' represents 
the marginal desirability of the money obtained. We now 
use these two curves just as we did those in Figure 35, and 
obtain the point s, the longitude of which is the quantity 
which the individual is willing to supply at the assumed 



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s 


/> 




























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m 








tP* 





















1000 


1000 


1000S 


C|00O 


1000 


I0OO 


X 



Fig. 36. 



SEC. 2] THE INFLUENCES BEHIND SUPPLY 283 

price Oy. By changing Oy and repeating the construction, 
we can obtain other points than s, thus constructing the 
supply curve showing the marginal cost of supplying 
different amounts of coal. 

In the supply curve, as we have just constructed it, the 
price is a minimum relatively to the supply ; that is, the 
curve shows the lowest prices at which given amounts will 
be supplied. Expressing this same truth the other way 
around, we may say that the supply is a maximum relatively 
to the price, i.e., the curve shows the greatest amounts which 
will be supplied at given prices. 

We see, then, that the total supply curve, analogously to 
the total demand curve, may be derived from a number of in- 
dividual supply curves (Fig. 34) ; that each such individual 
supply curve may be derived by assuming successive prices, 
and for this series of prices constructing (1) a curve of mar- 
ginal undesirability of furnishing the article, and (2) a de- 
scending curve of marginal desirability of money ; and that 
the supply curve is, or is equal to, an undesirability curve 
translated into terms of money. 

The important result is that the market price, as finally 
determined by supply and demand, is not only equal to the 
marginal desirability of getting coal for each buyer, but 
also to the marginal undesirability of furnishing it for each 
seller, both the desirabilities and the undesirabilities being 
measured in terms of money. Thus, if the price of coal is 
$5 a ton, the last ton bought by each buyer is worth barely 
$5 to him, while the last ton sold by each seller costs him 
about $5 worth of expense and trouble. 

These equalities on the margin of all sales and purchases, 
and the fact that the price must be such as will equalize 
supply and demand, i.e., " clear the market," are the funda- 
mental principles which determine the market price of any 
particular good. 

Remembering that supply curves and demand curves 
really are, or are equal to, undesirability and desirability 



284 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

curves, respectively, we note that market price is such a 
price as will equalize (in terms of money) all marginal de- 
sirabilities of buyers and all marginal undesirabilities of 
sellers, and at the same time equalize the total demand of 
all the buyers with the total supply of all the sellers. In 
short, market price results from the following two prin- 
ciples : — 

(1) The equalization of all marginal desirabilities and 
undesirabilities (both being measured in money). 

(2) The equalization of supply and demand. 

We cannot neglect either of these two principles. Nor 
can we omit either half of the first principle ; it is a mistake 
to think that price can be determined by marginal desira- 
bility alone or by marginal undesirability alone. It takes 
two sides to make a bargain and a market price. 

The present chapter, however, is especially devoted to 
the supply side. On the supply side of the market, there- 
fore, the great determinant of market price (in terms of 
money) is marginal cost (in terms of money) . 

The same principle would, of course, apply in terms of 
any other good than money or in terms of general purchas- 
ing power. We have already had occasion to anticipate 
this principle when considering the production and con- 
sumption of gold and silver. The price or purchasing power 
of gold, we found, depends not only on gold as money, but 
also on gold as a commodity. In the latter case its supply 
and demand need to be considered like the supply and de- 
mand of any other commodity. That is, so far as gold is a 
commodity like silver or coal, the study of its price (or, 
reciprocally, its purchasing power) involves the principles 
which determine prices in general. 

Our present study of prices, therefore, throws light on our 
previous study of gold. If the student will return for a 
moment to Figures 12-15, he will see that the distance below 
the line 00 of the highest outlet in operation from any 
bullion reservoir is simply what we would now call the mar- 



Sec. 2] THE INFLUENCES BEHIND SUPPLY 285 

ginal desirability of gold for use in the arts (measured in 
terms of general purchasing power over goods), and that 
the distance of the lowest inlet in operation is the marginal 
cost of production or undesirability of gold (measured like- 
wise in terms of general purchasing power over goods). 
That is, the mechanical representation there employed is 
merely another way of representing what we are now 
illustrating by supply and demand of money. 

We may now add that the differences in costs of producing 
gold, represented by the differences in heights of the inlets, 
are not altogether due to differences between mines, but 
also to differences in working the same mine. There is a 
marginal cost of production for each mine. The higher the 
speed of extracting, the higher the cost per ounce. This is 
called the law of increasing cost (per unit of product returned) 
or of diminishing returns (per unit of cost). It applies, of 
course, more generally than to gold and silver alone. In 
this chapter we have taken coal as our typical example. 
We might have taken numerous other examples. If the 
price of wheat rises, its marginal cost will rise. Just as a rise 
in price acts as an encouragement to the production of wheat, 
and just as we have seen that an encouragement in the pro- 
duction of gold leads to an opening of the poorer mines, 
so this encouragement to the production of wheat will lead 
to the cultivation of the poorer land. At a given price, there 
are always some lands on which it will not pay to produce 
wheat because of the prohibitive cost of production upon 
these lands. In gold mines, as in wheat fields, there is a 
marginal point of production beyond which production will 
not pay. The fertile lands of the Mississippi Valley are 
used for wheat production over wide areas, but this area 
always reaches a limit or margin of cultivation, the land 
beyond which is used for other purposes or not at all. As 
the price of wheat rises, this margin of cultivation is ex- 
tended. Poorer lands will be resorted to, and lands pre- 
viously under cultivation will be worked more intensively 



286 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

until, on all wheat lands, the cost (measured in money) of 
furnishing an additional bushel will again be equal to the 
price. 



§ 3. Upward Supply Curves which Turn Back 

In spite of the analogies we have noted between the supply 
and the demand side of the market, the differences between 
them are so great and important that the rest of this chapter 
will be devoted to them. 

Practically all demand curves descend to the right, and 
we have hitherto assumed that all supply curves ascend to 
the right. But not all supply curves do ascend to the right. 
One peculiar type of supply curve grows out of the fact re- 
cently noted, that there is a separate and descending curve 
of marginal desirability of money for every price assumed. 
This fact, when combined with the ascending curve of un- 

desirability of 
efforts and sacri- 
fices (as in Figs. 
35 and 36), tends 
to bend the 
supply curve up- 
ward — some- 
times so much as 
to cause it to curl 
back to the left, as 
in Figure 37. 
Such a curve, al- 
though it as- 
cends, does not, 
throughout all 
FlG its course, ascend 

to the right. It 
applies especially to the supply of labor. The meaning of 
such a supply curve is that a rise of price does not always 



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Sec. 3] THE INFLUENCES BEHIND SUPPLY 287 

cause an increased supply. At first it does, but beyond 
the point where the curve begins to curl back, a rise of 
price evidently results in reducing the supply. 

If we stop to consider the motives of a workingman, we 
shall see that this is true of him. If wages are low, a rise 
in them will at first stimulate him to work longer hours, 
but after a certain point he will prefer to rest on his oars. 
He earns so much in a few hours that he feels it is no 
longer necessary to work so hard. In South America, for 
instance, traders from Europe were once buying native- 
made baskets of a peculiar kind. In order to increase the 
supply of baskets, which was far less than they could mar- 
ket in Europe, the traders decided to raise the price that 
they would offer to the makers, thinking to stimulate the 
production of baskets by inducing the men to work more 
hours. Exactly the opposite result followed. As soon as 
these workmen were offered high prices for the baskets, 
they worked fewer hours and made fewer baskets than 
before ; they could now get more money even for doing less 
work, and they did not need or want more. Their wants 
were so few and simple that the marginal desirability of 
money to them decreased very rapidly with an increased 
amount of it; and their disinclination to work was so 
great that, combined with the feeble desirability of its 
rewards to them, they would supply less of it when 
the rewards were great than when they were small. That 
is (as shown in Fig. 37), as the price rose from the 
height of s' to that of s" , the supply of labor or number 
of hours spent in making baskets decreased from the longi- 
tude of s' to the longitude of s" . In the same way in 
the Philippine Islands it has been found that to raise the 
wages of workmen sometimes results in their working fewer 
hours in the day and fewer days in the year. One Spaniard, 
in order to keep his foreman, whom he considered very 
efficient, gave him a particularly high salary. The plan 
worked well for a few months, but at the end of that time 



288 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

the man had accumulated so much money that he had little 
desire for more, and decided to retire. Precisely similar 
instances have recently been cited among the negroes in the 
South. 

Now this same principle applies to all labor. Experience 
indicates that as wages go up workmen demand shorter 
hours. The eight-hour movement of to-day is at bottom 
due to the fact that wages are high. When wages were low, 
men worked twelve hours a day ; now that they are high, 
they work only ten, nine, or even eight hours a day. The 
same principle explains why men with the highest salaries, 
instead of working longer hours than others, usually work 
shorter hours. The most highly paid grades of workmen 
work the fewest hours and take the longest vacations. 

The exact point in wages at which the curve begins to 
bend back, so that if wages are raised any higher the supply 
of work will diminish, depends on the particular conditions 
in each case, the size of the workman's family, the range 
and character of their wants or their " standard of living," 
and other similar conditions. The more wants a man has, 
the higher the point at which the curve begins to bend back, 
i.e., the less easily is he satisfied with more money. 

§ 4. Downward Supply Curves 

The typical supply curve, with which we began, ascends 
continually to the right. In the exceptional case just con- 
sidered, the rightward movement was arrested and turned 
into a leftward movement. Our next exceptional case is 
that in which the curve does not even ascend, but descends. 
Such descending supply curves are common under modern 
conditions of factory production. It is often found that a 
large product costs less trouble, per unit, than a small prod- 
uct. In such cases, the marginal undesirability of furnish- 
ing the good decreases with an increase of supply, and not 
only decreases, but decreases in a faster ratio than does the 



Sec. 4] THE INFLUENCES BEHIND SUPPLY 289 

marginal desirability of money ; so that the ratio of the one 
to the other, i.e., the marginal cost, decreases with an increase 
of supply. 

When the marginal cost decreases with an increase of 
supply, the supply curve also descends, but its relation to 
the curve of marginal cost is now quite different from what 
it was in the case previously considered in which the curves 
ascend. The supply curve is no longer the curve of marginal 
costs, but must be constructed on an entirely new principle. 
The principle that market price is equal to marginal cost 
will no longer hold true. Only when the supply curve 
ascends will it be true that the price at which the seller is 
willing to supply a given amount is equal to its marginal 
cost, and is therefore derived from the curves of undesira- 
bility. Descending supply curves depend not on marginal 
cost at all, but on average cost. The reason is that no seller 
is willing to sell at a loss, and this is what he would be doing 
if he should offer to sell at prices corresponding to marginal 
cost when the marginal cost decreases with the amount sold. 
It is clear that, if the cost of supplying the 3000th ton of 
coal is $5, and the cost of all preceding tons is greater than 
$5, not even one ton of coal could be sold at $5 a ton with- 
out a loss, and if 3000 tons were sold at that price, there 
would be a loss on every ton except the last. Rather than 
sell 3000 tons or any less number at $5 a ton, the dealer 
would choose to sell none at all. Contrast this result with 
that which obtains in the case of an ascending curve. In 
this case the cost of supplying the 3000th ton was $5, but 
the cost of all preceding tons was less than $5, so that in- 
stead of a loss there was a profit on each of these preceding 
tons. Not only could he afford at $5 to sell 3000, but this 
amount gave him the maximum profit — more, for instance, 
than if he should sell 2000 or 4000 tons. In order that any 
dealer shall sell at all, he must expect to get back at least 
the total cost. This means that he must therefore charge a 
price at least as high as the average cost per ton. When the 



290 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

cost of each successive ton is greater than that of the preced- 
ing ton, the cost of the last, or marginal cost, is the greatest 
cost of all, and therefore exceeds the average cost. Conse- 
quently the dealer is assured a profit when selling at a 
price equal to the marginal cost. But when the cost of each 
successive ton is less than that of the preceding ton, the cost 
of the last (marginal cost) is the least of all, and therefore is 
less than the average cost. To sell at a price equal to 
marginal cost would, in this case, be to sell at a loss. 

In either case the seller will seek to determine his price 
on the basis of the higher of these two {i.e., marginal cost 
and average cost) . Whichever of the two is the higher will 
show itself in the supply curve. When the marginal cost 
increases with supply, marginal cost is the higher, and will 
rule supply. When the opposite is true, average cost is 
the higher, and will rule supply. 

In the latter case the supply schedule (or curve) is a 
schedule (or curve) of average costs. We need not describe 
in detail how to construct such a schedule (or curve) . This 
presents no difficulty, since we already know how to con- 
struct a schedule (or curve) of marginal costs which gives 
the cost individually of each separate ton. The simple 
average of any specified number of these is the average 
cost of that number. 

§ 5. Resulting Cutthroat Competition 

But, besides the fact that the ascending supply curves are 
based on marginal costs, and descending supply curves are 
based on average costs, the two types of supply curves offer 
another and even more important point of contrast. The 
supply at a price is in the first case the maximum which the 
seller is willing to offer at that price, whereas in the second 
case it is the minimum. In the first case, the more the 
seller can sell, the more he charges. In the second, the more 
he can sell, the less he charges. When we consider simply 



Sec. 5] THE INFLUENCES BEHIND SUPPLY 291 

ascending types of supply, we may express the relation be- 
tween the price and supply in two ways, either — 

(1) Given the quantity, the price is the minimum price 
at which that quantity will be supplied ; or 

(2) Given the price, the quantity is the maximum which 
will be supplied at that price. 

The first of these two propositions still holds true when 
the supply curve is descending instead of ascending ; but 
the second will not hold true until we have changed the 
word " maximum " to " minimum." In other words, when, 
as originally supposed, the supply curve ascends, the seller 
is willing at any given price to supply a certain amount 
or less; but, when the supply curve descends, he is willing 
at any given price to supply a certain amount or more. 

In the case of demand we found no such two classes as 
ascending and descending curves. In all cases demand de- 
creases as price increases. Consequently, there are not two 
ways of stating the relation between price and demand. 
The amount demanded at a price is always the maximum 
amount which will be taken at that price ; and the price 
is the maximum price which will be given for that amount. 

Let us then summarize our results, expressing each on 
the basis of a given price : — 

I. At a given price, each buyer is willing to take a certain 
maximum amount or less at that price. 

II. At a given price, each seller is willing 

(1) (in case marginal cost increases with an increase 

of supply) to offer a certain amount or less at 
that price. 

(2) (in case marginal cost decreases with an increase 

of supply) to offer a certain amount or more at 

that price. 

The contrast between the two types of supply, II, (i) and 

(2), is illustrated graphically in Figures 38 and 39. Figure 

38 illustrates case 1 and Figure 39, case 2. The curve in the 

first case is seen to be the maximum limit of longitude, and 



292 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 



in the second case the minimum limit. The longitude of 
any point in the shaded area represents an amount which 

the seller is will- 
ing to supply at 
the price corre- 
sponding to the 
latitude of that 
point. Thus, if 
we take any given 
horizontal line, 
such as ab, in the 
shaded area of 
Figure 38, its lati- 
tude represents 
an assumed price 
at which the seller 
is willing to supply 
any amount, from 



y Mil 1 LL1 


s 
: r 




-' 

















_ — /. 





























X 



Fig. 38 (Supply). 



nothing at the left end, a, of the horizontal line, to the 
maximum amount at the right end, b, where the line is 
limited by the 
curve. Taking 
any given hori- 
zontal line, such 
as ab, in the 
shaded area of 
Figure 39, the 
seller is willing 
to supply any 
amount from the 
minimum longi- 
tude (that of the 
point a at the left) 
up to an indefi- 
nite amount at 
the right; or, Fig. 39 (Supply). 



Y 


























































































































































































c 


lSr 








-b 




























V- 


--■ 


— 


— 








































































- 




































— 


































































^- 


-- 


































*s 








































































































O 
































X 



Sec. 5] 



THE INFLUENCES BEHIND SUPPLY 



293 



dropping the symbolism of the curve, the seller is willing 
at a given price to sell any amount from a certain mini- 
mum upward. 

In the latter case, i.e., when the cost of each additional 
unit of product is less than that of the preceding unit, the 
more the seller can sell at a given price, the better he likes 
it. If he sells only the minimum which he is willing to sell 
at that price, he gets back only his average cost of produc- 
tion, and makes no profit. Any sales beyond this bring 
him a profit, and the larger the sales, the larger the profit. 

This fact introduces us to an unexpected conclusion, viz., 
that if the total supply curve descends, the price repre- 
sented at the intersection of the supply and demand curves, 
although it clears the market, is not a stable price, but 
tends always to fall. Whether the price is above, at, or 
below, the latitude of the 
intersection, it will tend to 
fall so long as the supply 
curve descends. Let us 
consider each of these 
three cases separately, i.e., 
the price above, at, or be- 
low the intersection, allow- 
ing the demand curve to 
descend faster than the 
supply curve. If the price 
(Fig. 40) is OP, higher 
than the intersection, the 
demand exceeds the mini- 
mum supply and stimulates each supplier to furnish more 
than his minimum, which, of course, he is only too glad 
to do. Consequently, supply will soon overtake demand. 
Those competing to supply will strive to underbid each 
other, and the price will fall. 

But it will not stop falling at the intersection. For, sup- 
pose it is below, as at OP'. It is evident that it will con- 




Fig. 40. 



294 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

tinue to fall ; because then even the minimum supply ex- 
ceeds the demand, and all who compete to supply will be 
very eager not to be left with unsold goods on their hands. 
A rise of price would, it is true, remedy the difficulty. But 
no individual can apply this remedy. The individual com- 
petitor cannot raise prices without securing the agreement 
of others ; but to do this would be to create a combination 
which is contrary to our present hypothesis of independent 
action. If he should individually raise his price, he would 
be committing commercial suicide, for no people would buy 
of him when they could buy more cheaply of his competitors. 
His only hope of achieving his purpose of increased sales 
lies in adopting the opposite course, and underselling his 
competitors, regardless of the consequences to them and to 
the market price. His hope is that before they can meet his 
cut in price, he may win the patronage he needs to make it 
worth his while to stay in the market, and that he may thus 
drive some of his competitors out of business. If he fails 
to get the needed patronage, he must go out of business him- 
self. He therefore offers his wares at a price below OP'. 
If at this point many of his competitors should go out of 
business, he could succeed ; for though the total demand 
does not quite reach the supply curve, it will reach and pass 
his supply curve, which lies much to the left of the total 
supply curve shown in the figure. But his competitors 
remain, and under these conditions, as we have seen, there 
cannot be two prices in the same market at the same time. 
Hence all his competitors must reduce their prices to his. 

Whatever the effect of this action may be on the indi- 
vidual who first cuts the price, the result on the whole is 
evidently to make matters worse; for, according to con- 
ditions shown in the diagram, the lower the price, the more 
will the supply exceed the demand. 

We have here what is known as " cutthroat competition " 
or a " rate war," i.e., competition the effect of which is not 
simply to reduce profits, but to create losses. 



Sec. 6] THE INFLUENCES BEHIND SUPPLY 295 

§ 6. Resulting Tendency toward Monopoly 

But we have not yet reached the ultimate result of such 
competition. Some competitors must sooner or later see 
that there is no hope to secure the large sales necessary 
to make business worth while. They withdraw. This re- 
duces the losses for the rest ; for, by removing their supply 
curves, the total supply curve is reduced in longitude, i.e., 
is shifted leftward, and the discrepancy between supply and 
demand is lessened, if not done away with entirely. But 
even so, the tendency of the price to fall is not hindered ; for 
we have seen that, as long as the supply curve decreases, 
competition forces the prices down on whichever side of 
the intersection the price may be. In the case of a descend- 
ing supply curve, the intersection has nothing to do with 
the case. Competition with descending supply curves will 
always lower the price so long as there are any competitors 
with descending supply curves. No check to this fall is 
possible until either competition ceases or the supply curve 
ceases to descend. If the supply curve at some point at 
the right reaches a minimum point, this marks the lowest 
point to which the price can fall ; or if the crowding out 
of competitors finally leaves only one supplier in the field, 
he at that moment becomes a monopolist, and the prices will 
cease falling on that account. 

Monopoly may also come about in another way, as 
already suggested, i.e., by combination. When there is 
cutthroat competition, the motive to combine is strong. 
None of the competitors relish the prospect of being crowded 
out any more than they relish the prospect of continued 
cutthroat competition. Whether combination will actu- 
ally result or not depends on a variety of circumstances. 
One or more of the competitors may flatter himself that the 
rate war will end in crowding out all others except himself, 
and prefer to keep up the fight to the bitter end. Others 
may keep on from other motives, being prevented by pride or 



296 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVII 

resentment either from withdrawing from the contest or 
from begging their rivals to form a combination. But for 
our present purpose it does not matter much whether the 
monopoly which finally results comes from the final survival 
of one supplier or from deliberate combination of many sup- 
pliers. In either case the result is monopoly. 

We find, then, as a result of our study of the supply side 
of the market that supply curves sometimes descend, and 
that in such cases competition is " cutthroat " competition, 
and results in losses and tends toward monopoly. 

In all our reasoning we have assumed perfect competition 
to start with. It should be noted that in actual fact com- 
petition is usually somewhat imperfect. The slight under- 
cutting of prices by one grocer will not ruin the trade of 
another in another part of the same town for the reason 
that the two are not absolutely in the same market. Each 
has a sphere which the other can only partially reach, not 
only because of distance, but also because each has his own 
" custom," i.e., the patronage of people who, from habit 
or from other reasons, would not change grocers merely 
because of a slight difference in price. Thus each is pro- 
tected by his partial isolation. We see, then, that even when 
supply curves descend, competition may be so limited as to 
prevent any very fierce rate war, the rate war being pre- 
vented by partial or local monopolies among the suppliers 
in the first place. A rate war, therefore, is never a perma- 
nent or normal condition. If not avoided at first by imper- 
fect competition or by partial monopoly, it is brought to an 
end eventually by the monopoly to which it leads. 

§ 7. Fixed and Running Costs 

We have now to notice another peculiarity on the supply 
side of the market. The peculiarity referred to is the fact 
that there are often costs which do not vary with supply, but 
remain unchanged whether the supply is large or small or 



Sec. 7] THE INFLUENCES BEHIND SUPPLY 297 

nothing. These are called the fixed costs as contrasted 
with the costs which vary with supply, which are called the 
running costs. If all costs are in the form of actual money 
expenses, the two classes are also called respectively fixed 
expenses and running expenses. The fixed expenses of a 
railway company, for instance, consist of the interest on 
its bonds. The running expenses consist of the salaries, 
wages, and payments for fuel, materials, etc. The only 
costs hitherto included in our discussions were running costs. 
The fixed costs were not included, because they have no 
effect on variations in supply curves. We shall now study 
fixed costs merely to show that they do not have any effect 
on supply after once they have been incurred, a fact at first 
surprising. 

In general, fixed costs of production of any given goods 
consist simply of interest on past costs which have been 
" sunk " in the business, i.e., which cannot now be reim- 
bursed to the owner except as the sale of his goods may do 
so in part or in whole. As we have seen in a previous chap- 
ter, interest is not a cost to society, for it is merely a pay- 
ment from one person to another, an interaction. (See 
p. 76.) To society as a whole the only cost is the " sunk " 
cost, which, in the last analysis, consists, as has been ex- 
plained, of the labor expended at various times in the past. 
But to the individual supplier — and his is the only cost 
in which we are at present interested — interest is a cost. 
If he pays no interest, he must have incurred the " sunk " 
cost himself, in which case this past sunk cost constitutes 
his only fixed cost ; there is then no fixed annual cost. In 
one of the two ways he must bear the burden of sunk cost. 
That is, either he must have borne it in the past directly, or 
he must now be paying interest to some one else who so bore 
it. The two ways are equivalent in the same sense that two 
goods are equivalent which exchange for one another. That 
is, a sunk cost of $100,000 is equivalent, if interest is five 
per cent, to a fixed cost of $5000 a year. Whether the 



298 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

individual person or company has sunk the $100,000 in the 
past or is paying $5000 a year to some one else who did — 
in neither case does this cost enter into the cost (or un- 
desirability) curve, or the resultant supply curve, or the 
resultant price. 

We shall cite some examples which have been almost 
literally realized in actual life. A man once sunk about 
$100,000 in a hotel on the top of a mountain. He found 
that so few guests wanted to go there that the most he 
could earn was $2000 beyond his running expenses. He 
never succeeded in recovering the sunk cost, and the fact 
that he had sunk $100,000 gave him no power to com- 
mand prices high enough to enable him to succeed. Nor 
could he withdraw from the business and recover his 
$100,000. His total building was worth nothing except for 
hotel purposes. He could only make the best of his mis- 
investment and run his hotel for the sake of $2000 a 
year. This was better than nothing at all, which would 
have been the result of going out of business. The $100,000 
sunk in the past was sunk just the same, whether the hotel 
was run or not. Another hotel [keeper borrowed $100,000 
on bonds and paid interest at five per cent, i.e., $5000 a year, 
to the bondholders. His business paid running costs, but 
only $2000 beyond those costs, so that he failed by $3000 
to earn enough to pay his interest to the bondholders. 
The hotel was losing, in actual money expended, $3000 a 
year. But even in this case the hotel could not be aban- 
doned. The only result was to change owners. The bond- 
holders foreclosed their mortgage and ran the hotel them- 
selves. As it still earned $2000 beyond running expenses, 
they found it more profitable to continue the business and 
get two fifths of their interest than to close and get nothing. 

In either of these two cases, whether the hotel was built 
by the owner out of his own purse or out of borrowed money, 
there was a loss equivalent to three fifths of the original 
cost, or, what amounts to the same thing, three fifths of the 



Sec. 7] THE INFLUENCES BEHIND SUPPLY 299 

interest thereon. Yet this cost could not be avoided, 
whether the hotel business were large or small or abandoned 
altogether, and it " paid " to run at a loss rather than to 
close down at a greater loss. This paradox, that " it some- 
times pays to run at a loss," is important to analyze and to 
understand. 

A third hotel keeper made a lucky hit with his $100,000. 
He got not only his running expenses and interest on the 
$100,000, but a handsome profit besides. But this fact did 
not affect the prices at which he was willing to supply ac- 
commodations. He still charged as much as he could. 

The point to be emphasized is that in all three cases the 
fixed costs had no influence on prices. Whether these costs 
are easy to carry, as in the last case, or burdensome, as in 
the other two, they have no influence on prices. In each 
case the owner tries to make the most he can. The fixed 
costs take out the same amount, whatever he does, and may 
therefore be disregarded in deciding what is best to do. 

It follows that fixed costs will not even prevent prices, 
under the stress of competition, from going below what will 
pay those costs. A railway may be making money enough 
to pay both its running and fixed expenses and a handsome 
surplus besides, until a parallel road is built. Then each 
tries to take business away from the other ; a rate war en- 
sues, and prices of freight and passenger services are driven 
down. Each road is now running behind on its interest 
payments, yet neither can afford to stop running, for then 
it would run behind still further. We have here the same 
cutthroat competition as when the supply curve descends, 
except that in this case it is " cutthroat " because of the 
fixed costs. If also the supply curve descends, then there 
are two conditions tending toward cutthroat competition ; 
namely, the existence of fixed costs and the existence of the 
descending supply curve. As a matter of fact, these two 
conditions are often united. 



300 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

§ 8. General and Particular Running Costs 

The two are not only often associated, but are at bottom 
very similar to each other. This may best be seen if we 
divide one of the two classes of costs, running costs, into 
two subclasses, " general " costs and " particular " costs. 
By general costs, also called "overhead costs," are meant 
costs which, though they could be got rid of if the business 
ceased, will not greatly vary whether the business is large 
or small. They include the labor of superintendence, sal- 
aries of the chief officers, rent of rented quarters, interest 
on short- time loans for stock carried, etc., power, lighting 
and heating, insurance and repairs. By particular costs 
are meant those which apply to each particular unit so that 
their total amount will vary almost or quite in proportion 
to the amount of product sold. They include cost of raw 
materials and ordinary wages. 

Now when the supply curve descends, i.e., when running 
costs decrease with increase of supply, the reason is usually 
found in the " general costs." As the total " general costs " 
remain little changed by an extension of the supply, the 
general costs per unit supplied grow smaller, the larger the 
supply. These costs, added to the particular costs, which re- 
main practically the same, evidently cause the total running 
cost per unit to decline with an increase in production. For 
instance, let us suppose a shoe factory in which the general 
costs (for office salaries, heating, lighting, rent, insurance, 
etc.) amount to $100,000 a year, while the particular costs 
for materials (leather, etc.) and labor applied to the mate- 
rials (cutting, sewing, etc.) amount to $1 per pair of shoes. 
It is evident that the greater the product, the less the cost 
of shoes per pair. If 10,000 pairs are produced per an- 
num, the share of the general costs ($100,000) which each 
pair must bear will be $10. This, added to the particular 
cost for each pair ($1), will make a total cost per pair of 
$11 ; but if the output of the factory is 100,000 pairs, the 



Sec. 8] THE INFLUENCES BEHIND SUPPLY 301 

share of the general cost ($100,000) which each pair must 
bear will be only $1, which, added to the particular cost ($1 
per pair), will make a total cost per pair of $2. Thus we 
see that the total cost per pair will in each case be the 
particular cost, $1, plus the share in the general cost, which 
will be large for a small output and small for a large output. 

Now the reason that fixed costs were not treated like 
general costs and included in the computation of the 
average cost per unit, was that, as we have seen, fixed 
costs could make no difference in the price at which the 
supplier is willing to supply a given amount. The supplier 
is not willing to sell at prices below what is necessary to 
cover general costs, for he has the option to escape these 
general expenses by going out of business entirely. But 
he is willing, if need be, to sell at prices below what is nec- 
essary to cover fixed costs ; for from these there is no way of 
escape. He might have escaped them once had he not made 
the original investment, but now it is too late. The dif- 
ference between fixed and general expenses, then, is chiefly 
one of dates. When a man is contemplating building a 
hotel, and forecasting his possible profits or losses, he will 
try to make his prospective prices cover fixed costs, for they 
are then in the future ; but after the hotel is built, he will 
no longer do this. The fixed costs are then past and beyond 
recall, and he must let bygones be bygones. 

Since, then, his running cost and supply curves are inde- 
pendent of fixed costs, the price which results from this 
supply curve and the demand curve will also be independent 
of the fixed costs. This conclusion is consistent with what 
has been said in previous chapters as to price and value being 
dependent on the future and not on the past. We have 
seen that, on the demand side, people who buy any good 
buy it on the basis of what benefit it will do them in the 
future ; now we see that, on the supply side, those who 
sell it, sell it on the basis of what it will cost them in the 
future to continue in the business, and not on the basis of 



302 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

costs which were sunk in the past. The principle has been 
stated (somewhat imperfectly) as follows : — 

" The price of any article (when once it has been produced) 
is not determined by its cost of production, but only by its 
benefits." The imperfection in this statement is its failure 
to discriminate past from future. The costs of production, 
if they be future, do enter into value, precisely as future 
benefits enter. Future costs are estimated in advance 
just as future benefits are. For instance, the value of the 
great irrigation plants in the West now in process of con- 
struction is dependent upon their future expected bene- 
fits, taken in connection with the future expected cost of 
completion. Past elements are without significance. The 
future elements being given, the value of the irrigation will 
be the same whether the past cost Was large or small, or 
nothing at all. Of course it is true that the future expected 
cost for completing the plants is less than if some of the work 
had not been already accomplished, so that the greater the 
past cost has been, the less the future cost ought to be, 
and hence the greater the present value of the plants. But 
whatever causes may increase or decrease future benefits 
and costs, it remains true that the present value of anything 
depends exclusively on future benefits and costs which it 
yields. 

§ 9. Monopoly Price 

The supreme principle which guides economic action is 
the principle of maximum gain. This principle applies 
both to competition and monopoly, but its application is 
different in the two cases. In the case of competition the 
price set by a man's competitors is an important element 
which must be reckoned with by that man, while in the case 
of monopoly he has no such element to reckon with. In 
fact, monopoly is best defined as absence of competition. 

In explaining the principle on which monopoly price is 
fixed, we shall first assume that competition is entirely 



Sec. 9] THE INFLUENCES BEHIND SUPPLY 303 

absent, there being no fear even that high prices will lead 
to competition in the future. 

Under these circumstances the monopolist will fix his 
price with an eye to the expected effect on demand. He 
will charge " what the traffic will bear," i.e., will put up 
his price to the point which will give him a maximum profit. 
The higher the price, the larger the profit per unit sold. 
But, if he makes his price too high, he kills the sales. If, 
on the other hand, he makes it too low, he kills his profit 
per unit. By trial and error or by exercise of his best judg- 
ment, he steers a middle course, and selects that price 
which he thinks will render his profit a maximum. 

In general, the price under monopoly will be higher than 
under competition, but this will not always be the case if, 
as often happens, the costs under monopoly are less than the 
costs under competition. In some cases monopoly results 
in lowering costs so much that the greatest profit is secured 
by setting the price lower than under competition. Such 
economies in cost come from getting rid of duplications in 
plant, management, and advertising, and by having the 
advantages in general of large-scale production. 

When monopoly price exceeds price under competition, 
there is usually danger that competition will thereby be 
invited. Practically such danger is seldom absent. Com- 
petition which is feared, but not in actual existence, is called 
potential competition. This potential competition has an 
effect similar to real competition, so that under monopoly 
the price is usually not quite " all the traffic will bear," but 
something between that and the price that would result from 
actual competition. In general, prices are seldom deter- 
mined under conditions either of perfect monopoly or of 
perfect competition. There is usually a partial monopoly, 
or, what is the same thing, imperfect competition. 

There are many and obvious evils in monopoly. The evils 
of high prices are the least of these. There are also the 
evils involved in the ruthless process of crushing competitors 



304 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVII 

by first lowering prices and then raising them; there are 
the evils of discrimination, or charging different prices to 
different persons or localities. There are also the dangers 
of political corruption and control. The reader will have 
an opportunity in other books to study these evils and 
the proposed remedies. He should, however, avoid the 
common but false conclusion that all monopolies are evil. 
In fact, a chief lesson from this chapter is that, on the 
contrary, competition itself is sometimes an evil, i.e., when 
it is of the cutthroat kind, for which some form of mo- 
nopoly is the only remedy. When any business involves a 
large sunk cost or has a descending cost curve, and there- 
fore a descending supply curve, competition becomes of the 
cutthroat kind. Even if we deny our sympathy to those 
producers who lose by such competition, we must not fail 
to note that in the end consumers will lose also. The 
reason is that when cutthroat competition is feared, pro- 
ducers will avoid sinking capital in such enterprises. It 
is largely in recognition of this fact and in order to en- 
courage such investment that patents and copyrights are 
given. These are monopolies expressly fostered by the 
government. Herbert Spencer once invented an excellent 
invalid chair, and, thinking to give it to the world without 
recompense to himself, did not patent it. The result was 
that no manufacturer dared risk undertaking its manu- 
facture. Each knew that, if it succeeded, competitors would 
spring up and rob him of most or all of his profits, while, 
on the other hand, it might fail. Enforced railway com- 
petition has sometimes resulted in killing railway enterprise. 
The rise of trusts, pools, and rate agreements is largely 
due to the necessity of protection from competition, pre- 
cisely analogous to the protection given by patents and 
copyrights. 

Combinations are largely the result of the two conditions 
we have been considering — the fact that the supply curve 
descends, and the fact that there is large invested capital. 



Sec. 9] THE INFLUENCES BEHIND SUPPLY 305 

The antitrust movement, in so far as it aims to compel 
"competition, does not take these facts into account ; nor does 
it understand the necessities which have led to monopoly ; 
nor does it appreciate that, if we do not allow some form 
of trade agreements, trade is practically impossible to-day. 
Restrictive measures should be directed toward the control 
of monopolies and combinations, not to the restoration of 
competition. At the present time the general tendency is 
towards those forms of production in which cutthroat com- 
petition figures and in which monopoly must ultimately 
rule. It must not be supposed, however, that all or even 
most of productive enterprise is of this character. There is 
an immense field in which the older form of competition 
still holds sway; that is, in which marginal cost increases 
with increased production so that the supply curve is of the 
ascending, not the descending, type. In such cases com- 
petition is still the " life of trade " and affords a safeguard 
for the consumer against exorbitant prices. Such com- 
petition needs no regulation, and in general is better off 
without it. 



CHAPTER XVIII 

MUTUALLY RELATED PRICES 

§ i. Arbitrage 

We have seen how the price of any particular good is 
determined under varying conditions of competition and 
under monopoly. In each case the particular price has been 
considered, quite apart from other prices. We found that 
each price was determined by its own supply and demand. 
But " supply and demand " were expressed by schedules 
(or curves) which in turn depend upon schedules (or curves) 
of desirability which themselves depend on innumerable 
outside conditions — among them being other prices than 
the particular price in question. In fact, we have seen that 
these separate curves are affected by the general level of 
prices. We now have to observe that they are also affected 
by other particular prices. 

In the first place it is evident that the prices of the same 
article in different markets act and react on each other. 
Thus, the price of wheat in Chicago affects the price of wheat 
in New York, Liverpool, and elsewhere. The fact that it 
can be transported quickly and cheaply from one market 
to another prevents the possibility of great differences in 
prices. Any considerable difference in prices between two 
markets such as Chicago and New York will soon correct 
itself through the transportation of wheat from the cheaper 
to the dearer market. If all communication between the 
markets could be cut off so as to prevent absolutely such 

306 



Sec. i] MUTUALLY RELATED PRICES 307 

transportation of wheat, the supply and demand schedules 
or curves in each market would be independent of those in 
the other, and the resultant prices in the two would fluctuate 
independently of each other. But, given cheap and rapid 
transportation, the supply and demand in one market will 
closely affect and be affected by the supply and demand in 
the other, and there will be a tendency toward equalization 
of prices. In the two this equalization tendency works 
itself out chiefly through a special class of men who make 
it their business to watch prices in different markets, en- 
deavoring always to buy in the cheaper and sell in the 
dearer. Such transactions are called arbitrage transactions. 
These men engage in the business of arbitrage in order to 
take advantage of price differences ; and while it is not 
their object or wish to equalize prices (for it is on the in- 
equalization of prices that they live), nevertheless, to 
equalize prices is the effect of their action. 

Suppose, for instance, that the price of wheat in Chicago 
is 75 cents per bushel and in New York $1 a bushel. Such 
a situation offers an opportunity for an arbitrage merchant 
to make money rapidly by buying wheat in Chicago at 75 
cents and selling it in New York at $1 . He therefore appears 
in Chicago on the demand side of the market, being willing 
to take a large amount of wheat at 75 cents per bushel. He 
appears in New York, on the other hand, on the supply side 
of the market, being willing to sell a large amount of wheat 
at Si per bushel. Thus he increases the demand for wheat 
in Chicago and increases the supply in New York. The 
effect, as we have seen, must be to increase the price in 
Chicago and decrease the price in New York. 

The former may rise from 75 cents to 80 cents per bushel, 
and the latter may fall from $1 to 95 cents per bushel. But, 
even at these prices, the arbitrage merchant will be able to 
reap a rich harvest and will continue to do so until the dif- 
ference in price is sufficiently reduced. Instead of the prices 
remaining 80 cents and 95 cents, they become, let us say, 



308 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

85 cents and 90 cents and then 86 cents and 89 cents. This 
leaves the merchant a margin or difference of only 3 cents. 
But as the cost of transporting wheat from Chicago to New 
York is, we shall suppose, about 3 cents per bushel, there 
is no longer profit to the arbitrage merchant, and thus the 
equalization of prices will be limited by the cost of trans- 
portation. The price in New York can never be above 
that in Chicago by more than 3 cents per bushel. For 
similar reasons, the prices in Chicago cannot exceed those 
in New York by more than the cost of transportation; 
otherwise the arbitrage merchant would buy wheat in 
New York and sell it in Chicago. 

It is by such arbitrage transactions that the prices of the 
same commodity in different markets seek a common level, 
just as water flowing from one reservoir to another tends to 
equalize the levels of the two. The more the costs of trans- 
portation are reduced, the more nearly equal will the prices 
of any commodities in different markets become. With 
the progress of civilization, and especially with the improved 
means of transportation by railway and steamships, the 
equalization of prices of transportable goods has proceeded 
with great rapidity. The commercial world still consists 
of a number of separate markets, but the communication 
between these markets is becoming constantly more cheap 
and rapid, so that, in a sense, the whole world almost forms 
one great country for certain staples like wheat, other grain, 
and the precious metals. For articles which are difficult 
of transportation, bulky, and otherwise subject to expensive 
transportation in proportion to their value, the tendency 
to the equalization of prices is less striking. This is partic- 
ularly true of human services by " labor," which can only 
be transported through migration. Nevertheless, there is 
a constant tendency for migration to take place in order 
to take advantage of differences in the price of labor. Both 
the European and Oriental workmen often leave their low 
wages for the higher wages in America or other new countries. 



Sec. i] MUTUALLY RELATED PRICES 309 

Before the days of rapid transportation it was not uncom- 
mon for wheat to command famine prices in one country, 
while, at the same time, it was a glut on the market in 
another. 

It is evident that the equalization of prices is an advan- 
tage to the world as a whole, for it is better that there 
should be a moderate supply of wheat, and therefore of 
bread, throughout the world than that there should be in 
some places feast and in others famine. Therefore the 
intercommunication of markets and the resulting equaliza- 
tion of prices must be regarded as an advantage to society. 
It does not follow, however, that it is an advantage to 
every individual in society. 

For instance, when the fertile lands of the Mississippi 
Valley were tapped by building railways from the East, 
the cheap wheat from these lands began to enter the markets 
of the East, where the price of wheat had been relatively 
high. The result was to lower the price of wheat in the East. 
This reduction in price injured the New England farmer. 
Such injury of individuals almost inevitably happens with 
every economic readjustment of conditions. Rapid and 
cheap transportation by connecting all lands and countries 
has, in spite of the general good accomplished for the 
world as a whole, injured great groups of producers by 
subjecting them to competition from which the barriers of 
nature had previously protected them. These producers 
have therefore asked the government to protect them by 
raising artificial barriers in place of the natural barriers 
which have been destroyed, and the protective tariff has 
as its chief source of popularity the fact that it protects 
the local producer of particular articles against the importa- 
tion of such articles from abroad. The policy of protection 
is thus an attempt to interfere with the equalization of 
prices which the improvement in transportation is con- 
stantly producing. 

But just as this progress of equalization of prices creates a 



310 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

special injury to some particular producers, it creates special 
benefits to others. The transcontinental railways have not 
only injured the owners of the rocky farms in New England, 
but have vastly benefited the owners of the alluvial lands in 
the Mississippi Valley ; for they have given them an oppor- 
tunity to sell their products to advantage in the more rocky 
parts of the world. In general we may say that the equal- 
ization of prices constantly going on through improvement 
in transportation facilities injures the producer in those 
regions where prices were previously high, but benefits the 
producer in regions where those prices were previously 
low. The former group have, therefore, an interest in pro- 
tection; the latter, an interest in freedom of trade: the 
one, an interest which tends to prevent, and the other, an 
interest which tends to promote, the intercommunication 
of markets. Among consumers, on the other hand, opposite 
results ensue. Those particular consumers who were enjoy- 
ing the lowest prices are injured by the rise which equaliza- 
tion brings to them, while those who had to pay high prices 
are benefited by the fall which equalization brings to them. 
In general, the inevitable effect on society as a whole is a 
•gain, for the reason that a larger quantity of goods is 
obtained with a smaller expenditure of effort. It is evi- 
dently more economical for the world to grow its wheat 
in the Mississippi Valley than on the refractory soil of 
New England, and the transportation facilities which have 
brought about this condition have been of the same nature 
as labor-saving machinery. 

It is not within the scope of this book to discuss the argu- 
ment for or against the protective tariff, but the student 
can at this point realize that the movement for protection 
is of the same nature as the movement against labor-saving 
machinery, which is a protest against the cheapening pro- 
cesses which come from inventions, the protest being made 
by the special interests which are injured by the introduction 
of these processes. 



Sec. 2] MUTUALLY RELATED PRICES 311 

§ 2. Speculation 

We have spoken of the equalization of prices as between 
different places. We have next to consider equalization of 
prices as between different times. Corresponding to the 
tendency to the equalization of the prices of a given com- 
modity between different places, that is, between the places 
where it is abundant and cheap and the places where it is 
scarce and dear, there exists a tendency to the equalization 
of the prices of a given commodity at different times. More- 
over, the method of equalization of prices between times 
corresponds somewhat to the method of equalization of 
prices between different places. Just as the equalization 
between places is accomplished by the transportation of 
commodities, so the equalization between times is accom- 
plished by the transfer of the commodity from the time when 
it is abundant, and therefore cheap, to the time when it is 
scarce, and therefore dear. For instance, ice is abundant 
and cheap in winter, but scarce and dear in summer. Con- 
sequently much of it is stored in ice houses in winter and 
kept for use in the summer ; that is, the part which is thus 
stored is subtracted from the winter supply and added to 
the summer supply. The effect tends to equalize the prices 
of ice at different seasons. In the same way many vege- 
tables and fruits, such as potatoes and apples, which are 
abundant and cheap in the summer and fall, are to a large 
extent stored for use in winter when they will be scarce and 
dear. The effect is to subtract a certain quantity from use 
in the summer and fall and to add to the amount used in 
the winter. 

Just as the equalization of prices between places is largely 
due to the work of a special class of business men who engage 
in arbitrage transactions, so the equalization of prices be- 
tween different times is largely accomplished by a special 
class called speculators. A wheat speculator, for instance, 
withdraws wheat from the market when it is abundant and 



312 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIH 

cheap, and supplies it when it is scarce and dear. At the 
former times he appears on the demand side of the market 
as a wheat buyer ; at the latter he appears on the supply 
side as a seller. By thus adding to the demand when the 
price is low, he tends to raise prices, and by adding to the 
supply when the price is high, he tends to lower prices, thus 
acting as an equalizing agent. 

We need to distinguish two chief kinds of speculation 
according as the price of the given commodity is expected to 
rise or fall. When speculators expect the price to rise, their 
operations consist simply in buying wheat in the present, 
keeping it until the future, and then selling it again at higher 
prices. When, on the other hand, the price is expected to 
fall, the operation is somewhat more complicated. It is 
easy to decrease the present consumption of any commodity 
and increase correspondingly future consumption, i.e., to 
withdraw certain stocks and hold them until the future. 
Often, however, the reverse operation is needed, namely, 
to increase present consumption at the expense of future ; 
but evidently this is difficult. We cannot lay hold of a future 
stock of wheat before it exists. The best we can do is to use 
up our present wheat as completely as possible. This is what 
is needed when prices are falling, and it is accomplished 
through the operation of a particular kind of speculation 
called " selling short." Speculators will then add to the 
present supply by selling out any stocks from previous hold- 
ings. They and all who deal in wheat will refrain as far as 
possible from intentionally carrying over any of the present 
stock of wheat into the period when they expect it to be 
abundant, and therefore cheap. But this is not all ; the 
speculators will also speculate for a fall by " selling future 
wheat short." This operation of "selling short" consists 
in agreeing to sell wheat in advance of the time of delivery, 
depending on its expected advance to enable them to secure 
the wheat in time to fulfill their contracts. It is called 
" selling short," because the speculators are selling some- 



Sec. 2] MUTUALLY RELATED PRICES 313 

thing which they do not yet possess, i.e., of which they are 
" short." The speculator who sells short hopes to make a 
profit by buying at a lower price than the price at which 
he sells short. If, for instance, in January the price of 
wheat is low, say $i a bushel, he sells May wheat, that 
is, wheat deliverable in May, at 90 cents a bushel. This is 
because he expects that when May comes, wheat will be 
worth less than 90 cents a bushel, say 85 cents, so that 
he can buy it for 85 cents and sell it immediately to his 
customer for the 90 cents previously agreed upon. 

The effect of selling wheat short is to encourage still 
further the using up of present supplies, the speculator thus 
guaranteeing the delivery of wheat to those who buy of 
him so that these persons will not need to accumulate the 
wheat in advance for themselves. Of course, the speculator 
must take good care that the wheat is available at the time 
agreed, but, being presumably an expert as to the conditions 
of wheat supply, he can manage to get the wheat in the nick 
of time or, at any rate, with less preliminary accumulation 
than those who are not experts. The effect is therefore to 
greatly economize the use of wheat in the present and avoid 
the necessity of any one's keeping wastefully on hand any 
large stock. Where such a speculative market exists, a 
miller can, when wheat is scarce, use up his existing stock 
without replenishing it until the last minute, at which time 
he has the assurance of those who have sold him wheat short 
that the wheat will be on hand. Without such assurance 
from experts in wheat speculation, the miller would have 
feared to have run his stock so low and would have laid in 
wheat in advance even at high prices. He defers his stock- 
ing up by means of the short selling of wheat to him by the 
speculator. And not only does he personally gain the ad- 
vantage of deferring his purchase until prices are lower, but 
the public is also benefited. 

In the same way a woolen manufacturer is enabled in 
a speculative market to lay in his supply of wool in the 



314 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

most advantageous manner. If the price of wool is fall- 
ing, he will wait before stocking up, merely contracting 
in advance with a speculator for the immediate delivery 
of new wool, when his present stock is exhausted. In the 
same way building contractors use the speculative market 
to assure themselves of building materials when needed. 
The contractor arranges in advance for the delivery to 
him of the lumber, bricks, and stones needed. By thus 
selling short or making contracts for delivery in advance 
of possession, and sometimes even in advance of the actual 
commodity sold, there is a great saving accomplished in 
the stocks which need to be carried. Without such selling 
of futures the miller, the woolen manufacturer, the builder, 
and great classes of merchants would be under the necessity 
of carrying far larger stocks than they now carry. In 
other words, the speculative operation known as selling 
short enables the community to economize its capital exist- 
ing in the form of accumulated stocks of goods, especially 
at times when these goods are scarce and dear and most 
need to be economized. This selling short has the effect of 
deferring the demand for a commodity. The miller, the 
woolen manufacturer, the builder, and all others who buy 
futures — the wheat, the wool, the building materials, etc. — 
do so instead of buying present wheat, wool, building mate- 
rials, etc. The fact that they find a speculative market in 
which they can buy futures has therefore, as its effect, less 
buying in the present. In other words, it reduces the pres- 
ent demand, and therefore reduces the present price, while 
it increases the future demand and the future price. Thus 
it tends to reduce the gap between the present high prices 
and the future low prices. 

But while speculation normally tends to mitigate either 
an impending rise or fall of prices, its power to do so is 
limited, just as is the power of equalizing prices among dif- 
ferent places by arbitrage. The latter operation does not 
pay when the difference in price is reduced to the ctfst of 



Sec. a] MUTUALLY RELATED PRICES 315 

transporting from place to place. Likewise speculation 
does not pay when the expected difference in price becomes 
too small. One of the costs to the speculator for a rise is 
interest on the capital he locks up when he withdraws a 
commodity from the market and holds it for a certain period. 
Suppose, for instance, that he borrows money in order to 
speculate for a rise. The anticipated rise must be suf- 
ficient to cover this interest and all the other costs involved 
in the operation. Otherwise the speculation promises a 
loss instead of a gain. Likewise, if he is to speculate for 
a fall, he must anticipate a fall sufficiently below the price 
at which he sells short to enable him to make a profit. 
Speculation, therefore, is a function in equalizing prices 
between times, very analogous to the function of arbitrage 
transactions in equalizing prices between different places. 
But there is one important distinction between speculation 
and arbitrage. Speculation, by the nature of the case, in- 
volves uncertainty in a far greater degree than arbitrage. 
The prices among different places can easily be known, but 
the prices between different times are far more difficult to 
know, for the future is always uncertain. All we can do 
is to predict according to the best information we can get. 
It therefore often happens that the speculator makes a mis- 
take in his forecast of the future. He may believe that 
prices are rising when they are really falling, or falling when 
they are really rising. If, acting on the mistaken belief that 
prices are rising, he holds wheat for a rise, the result of his 
action will be to aggravate the fall ; for buying in the present 
will raise prices now when they are already high, and selling 
in the future will lower them then when they will be low. 
In like manner, if he makes the mistake of selling short when 
prices are rising, he will aggravate the rise, for he will lower 
the consumption in the present when prices are already low 
and raise them in the future when they are already high. 

Therefore speculation may do either good or harm. It 
does good when it reduces the inequality of prices at different 



316 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

times. It does harm when it aggravates this inequality. 
Fortunately, the interests of the speculator and the public 
are to a large extent identical. It is evident that when the 
speculator is correct in his prognostications, he will make 
a profit. His object is to make a profit when prices are rising, 
but he can do so only by mitigating the rise. Likewise his 
object is to make a profit when prices are falling, but he can 
do so only by mitigating the fall. His profits are, as it were, 
a price paid him by the community for mitigating price 
changes. If he makes a mistake in either form of specula- 
tion, he suffers losses, and these losses may be regarded as 
a sort of penalty he suffers for aggravating the inequalities 
in prices. Since the interests of the speculator and of the 
public are thus parallel, there is a premium put on wise and 
beneficial speculation and a penalty on unwise and injurious 
speculation. 

It is unfortunately true, however, that in spite of the 
penalties for unwise and injurious speculation, much specu- 
lation is of this character. This is largely due to the fact 
that many engage in speculation who have no adequate 
equipment for so doing and no independent judgment as to 
the causes making for a rise or a fall in prices. The ultimate 
justification for speculation must rest in the wisdom and 
independence of those who speculate. Speculation which 
merely follows a " tip " has no independent value. If 
every person who speculates for a rise or a fall should do so 
on a basis of his own best independent judgment, the chances 
are that mistakes of those who are overconfident in either 
direction would largely offset each other. 

During recent years the general public has been beguiled 
into the folly of entering the speculation market, but the 
public has no special knowledge of market conditions, and 
their participation in speculation is therefore as apt to 
aggravate as to alleviate the inequalities in prices. In such 
cases speculation becomes mere gambling. In fact, it is 
worse than gambling, for the evils are more extensive, -being 



Sec. 3] MUTUALLY RELATED PRICES 317 

shared by the consumers and producers and all who are 
affected by the price fluctuations thus caused. Such evils of 
speculation are especially grave when, as usually happens, 
the general public speculate, since their forecasts are made 
second-hand. Like sheep, they tend to follow the same 
leader, and the great bulk of their mistakes are apt to be in 
the same direction, first in one direction and then in the 
other. The effect of their movements is like that of a 
sudden rush of the passengers of a ferryboat first to one 
side and then to the other, — it may cause a capsize. 

We see, then, that the chief evils of speculation are largely 
the work of the unprofessional speculators, just as the chief 
evils of reckless automobile driving are due to untrained 
chauffeurs. It must not be supposed, however, that the pro- 
fessional speculator is always a public benefactor. Not only 
may he also make mistakes which would cost him and 
society dear, but he may sometimes "rig the market" and 
manipulate prices. When a professional speculator merely 
attempts to take advantage of an impending rise or fall of 
prices, he is usually a public benefactor; but when he 
attempts to create the rise or fall, of which he is to take ad- 
vantage, by false reports, by "cornering," or by other 
means, he is apt to be a mischief-maker. 

This is not the place, however, to discuss the benefits and 
evils of speculation further than to warn the student against 
the wholesale condemnation of speculation so common in the 
public press. Like most other industrial operations, specula- 
tion may be either good or bad. So far as it is good or bad, 
the discussion of the two belongs to applied economics. Our 
object here is to show that speculation, so far as it is good, 
tends to equalize prices in time. 

§ 3. Prices of Goods which Compete on the Demand Side 

As a result of our study of arbitrage and of speculation, 
we see that the price of any particular commodity at any 



318 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

time and place, though directly fixed by its supply and de- 
mand at that time and place, is indirectly affected by the 
supply and demand at other times and places; for these 
react upon supply and demand at the particular time and 
place under consideration. The price of wheat in Chicago 
on January i, 191 2, is determined by the intersection of the 
supply and demand curves in Chicago on that date; but 
those supply and demand curves depend, as we now see, upon 
the price of wheat in St. Louis, New York, Liverpool, and 
other places, and depend likewise on the prices of wheat 
on dates before and after January first. The price of wheat 
in Chicago on January first tends to be close to the price of 
wheat in neighboring places and at neighboring times. 

Not only does the supply and demand of wheat at any 
time or place depend upon the price of wheat at other times 
and places, but it depends likewise on the prices of other 
things than wheat. In particular the price of wheat de- 
pends on the prices of substitutes for wheat to those who 
demand them when they fill similar needs. Substitutes for 
wheat will resemble wheat in affecting the price of wheat, 
but the effect will not be so direct if the substitutes are only 
substitutes on one side of the market ; that is, if they are like 
wheat so far as the use to the consumer is concerned, but 
unlike wheat so far as the cost to the producer is concerned. 
Sugar and honey are substitutes to those who demand 
them, for they serve similar needs so far as the consumer 
is concerned, though on the supply side they are produced 
in totally different ways. 

Two sorts of wealth are said to be substitutes on the de- 
mand side when they fill similar needs. It follows that the 
satisfaction of needs by one of the two substitutes not only 
reduces its marginal desirability, but affects the marginal 
desirability of the other in a similar fashion. Consequently, 
the marginal desirabilities of the two tend to fall or rise in 
unison. Therefore also the prices of the two tend to fall or 
rise in unison. It is evident, for instance, that the price 



SEC. 3l MUTUALLY RELATED PRICES 319 

of coal will affect the demand for coke, since coal and coke 
are often substitutes, or competing articles. The more 
nearly either of the two articles comes to rilling the office 
of the other, the more closely do their prices keep pace 
with each other. If two articles are absolutely perfect 
substitutes, they are, to all intents and purposes, the same 
article, and have the same price. 

There is scarcely an article which does not have its sub- 
stitutes. The two fuel substitutes, coal and coke, include 
numerous subclasses and varieties, such as anthracite and 
bituminous coal. Other fuel substitutes are wood, petro- 
leum, gasoline, alcohol, and gas. A change in the price of 
any one of these tends to produce a similar change in the 
prices of the rest. Likewise the prices of food substitutes 
are sympathetic among themselves — the prices of such sub- 
stitutes as wheat, corn, oats, rice, and barley ; of fish, meat, 
and fowl ; of the various fruits and the various vegetables. 
Similar sympathetic relation exists among clothing sub- 
stitutes, such as woolen, cotton, linen, and silk ; or among 
ornamental substitutes, such as diamonds, pearls, rubies, and 
amethysts. 

The closest substitutes, though still sufficiently distin- 
guishable to prevent their being quite classed as the same 
article, are the various " qualities," " grades," or " brands " 
of any particular class of articles. There are many grades 
of wheat, of sugar, of coffee, of meat, of silk, and in fact of 
almost any class of articles which can be named. Among 
different grades the prices are usually so closely parallel 
that trade journals often give the price of one staple grade 
only — as of a standard grade of coffee — leaving it to the 
reader to infer what the prices of the other grades must be. 
But the prices of different qualities of any good, though 
they rise and fall together, may be wide apart among them- 
selves. Various qualities of land, for instance, bring very 
different prices, ranging from almost nothing to thousands 
of dollars per square foot. When the various "qualities" 



320 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVIII 

yield precisely the same sort of benefit, the only differences 
among them are differences in the quantities of benefits 
which flow from them. In this case the prices of the goods 
will evidently be proportioned to the net benefits they yield. 
Wheat lands, for instance, of different fertility, will be worth 
prices proportioned to the quantities of wheat which they 
yield. 

§ 4. Prices of Goods which are Complementary on 

the Demand Side 

* 

Substitutes may be said to compete with each other. We 
now consider articles which complete each other or, in 
other words, are complementary. Complementary articles 
jointly serve the same want. We have seen that of two 
substitutes one is used instead of the other for a given pur- 
pose. But of two complementary articles one is used in 
conjunction with the other for a given purpose. Horses and 
mules are substitutes, so far as either may be used for 
the purpose of drawing loads. A horse and a cart are 
complementary, for this same purpose. 

We have seen that the essential attribute of substitutes 
is the tendency of their marginal desirabilities to keep 
pace with each other, and the consequent tendency of their 
prices to correspond. In the case of complementary articles 
it is the quantities of the articles which tend to maintain 
a constant ratio. In the case of perfect substitutes the ratio 
of their prices is absolutely constant. In the case of perfect 
complementary articles it is the ratio of the units used that 
is absolutely constant. Right and left shoes, for instance, 
being practically perfect complementary articles, the num- 
bers of rights and lefts keep in a ratio of equality. One- 
legged people are too few to seriously modify that relation. 
The prices of two substitutes tend to move sympathetically, 
but the prices of two complementary articles tend to move 
inversely. If horses are abundant, and therefore cheap, 



Sec. 5] MUTUALLY RELATED PRICES 32 1 

the tendency is to make mules, which are a substitute, cheap 
also, but to make the complementary carts dear; for the 
more horses used, the more carts will be needed, and the 
increased demand for them will tend to raise the price. 

Articles which are related to each other in this comple- 
mentary fashion are almost as common as those which are 
related to each other in competitive fashion. Various articles 
of food are used in combination, as, for instance, bread and 
butter, or the elements of which a sandwich is composed. 
A daily diet is usually constructed with regard to the fitting 
together of the different courses served, and of the meals 
as a whole. Similarly, the various parts of one's wardrobe 
are arranged with reference to one another; and again, a 
dwelling and its various furnishings are mutually adapted. 
The tables and chairs, crockery, knives and forks, beds 
and bedding, rugs and wall paper, are severally arranged in 
relation to one another in their respective groups, and to the 
house to which they all constitute a complement. 

§ 5. Similar Relations on the Supply Side 

Thus far we have considered only goods which compete 
with each other, or complete each other, in respect to 
demand. Turning now to the supply side of the market, 
we find similar relations. 

Two goods compete in supply when they occasion similar 
efforts or costs to those who sell them. Thus, hay and 
wheat — though far from being substitutes on the demand 
side, satisfying dissimilar wants — are to some extent sub- 
stitutes on the supply side, for they require similar costs. 
Both require the use of farm land and the labor of mowing 
or reaping. The prices of such articles competing in supply, 
like those of articles competing in demand, tend to rise 
or fall together. The best example of competition of costs 
is found in the services of laborers. The wages, or the prices 
paid for various kinds of work, tend to keep pace with each 



322 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

other. Man is so versatile a machine that one kind of 
workman can readily substitute for another. On a pinch, 
the same man may be a factory employee, a farm hand, a 
coachman, carpenter, mason, plumber, or clerk. Conse- 
quently, these various sorts of work, though filling very 
unlike wants on the demand side, compete on the supply 
side, and tend to bear similar prices. If the wages of clerks 
rise, the wages of carpenters will rise also, because otherwise 
many carpenters would want to become clerks. The con- 
sequence is that wages of all sorts usually rise or fall 
together. If labor of all kinds could be perfectly sub- 
stituted, wages of all kinds would remain in absolutely fixed 
ratios to each other, i.e., would rise or fall together in exactly 
the same ratios. Such " perfect mobility of labor," however, 
never exists. On the contrary, labor may be classified 
into several more or less " noncompeting groups," such as 
brain work, skilled work, and unskilled work. 

Two goods complete each other in supply, or are comple- 
mentary on the supply side, when jointly they involve 
the same cost, i.e., when the supply of one tends to carry 
with it the supply of the other. The less important of the 
two is then called the by-product of the other. Tallow 
is a by-product of beef and hides. Other examples of 
articles completing each other in supply are mutton and 
wool ; coal, coke, and gas. 

The prices of two completing goods on the supply side 
tend to move in opposite directions, just as we saw was 
the case on the other side of the market. Consider, for 
instance, beef and hides. If the price of beef rises, the 
amount supplied at the higher price will increase. Hence 
the supply of hides will be increased at the same time. Con- 
sequently their price will fall. 

We see, therefore, that two articles may be substitutes 
on the demand side by replacing each other in satisfying 
the same sort of desires, or on the supply side by requiring 
the same sort of costs; and also that they may be com- 



Sec. 6] MUTUALLY RELATED PRICES 323 

plementary on the demand side by jointly satisfying the 
same desire, or on the supply side by jointly requiring the 
same costs. 

§ 6. Prices of " Tandem " Goods 

In all the cases thus far considered, the relationship 
between articles is on the same side of the market. We next 
proceed to consider goods, the relation between which in- 
volves both sides of the market. 

The supply of one article may have relationship to the 
demand of another. This is true of two articles, one of 
which is used in producing the other. Such goods may 
be called " tandem " goods, because one follows after 
the other in the process of manufacture. In this re- 
spect their relationship differs from the others discussed. 
Substitutes and complementary articles are, as it were, 
" abreast " of each other on the same side of the market, 
whereas wool and woolen cloth, for instance, go tandem on 
opposite sides of the market. Wool is used (as raw material) 
in producing woolen cloth. Hence the prices of wool and 
woolen cloth are intimately related to each other. The 
relation, however, is different from those relations hitherto 
considered. Wool and woolen cloth are not substitutes or 
complementary goods on the same side of the market. 
Their relation consists in the fact that the producers or sellers 
of woolen cloth are the consumers or buyers of wool. Both 
the demand and the supply side are involved. Woolen 
sellers demand wool in order to supply woolen cloth. 

The prices of tandem goods move in sympathy. It is 
evident, for instance, that given a high price for wool, the 
prices in the supply schedule (or curve) for woolen cloth 
will be higher than otherwise, and as a consequence the 
market price of woolen cloth will rise. Conversely, given 
a high price for woolen cloth, the prices in the demand 
schedule (or curve) for wool will be higher than otherwise, 



324 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVIII 

and as a consequence the market price of wool will rise. 
Thus, any change in price of either of these two articles 
will tend, sooner or later, to make the price of the other move 
in the same direction. 

In the same way cotton and cotton cloth are tandem 
articles, and their prices are likely to move in sympathy 
with each other ; likewise the prices of wood and houses, of 
wheat, flour, and bread; or of iron mines, iron ore, pig 
iron, rolled iron, steel, steel rails, and railways. This 
chainlike or serial relationship comprises many other ele- 
ments than raw materials and finished products. Thus, 
steel is related to the labor and coal consumed in its manu- 
facture in much the same way as it is to the iron ore out of 
which it is wrought. The price of steel therefore moves in 
sympathy not only with the price of iron, but with that of 
coal and labor as well and of all the other goods employed 
in its production. The series or chain of tandem goods is 
the chain of productive processes already discussed under 
the head of successive interactions. 

§ 7. Efforts and Satisfactions the Ultimate Factors 

This tandem relationship enables us to see clearly the fact 
that, at bottom, supply rests on efforts, and demand on 
satisfactions. We have seen in economic accounting that 
all items of income and outgo cancel among themselves, 
except efforts and satisfactions. We now see this same 
truth in its application to supply and demand. As simple 
as this truth is, it is commonly overlooked, because people 
are blinded by the all-pervading presence of money receipts 
and expenses. The business man, reckoning in money, 
comes to think of money expenses and money receipts as 
though they were real costs and benefits in the productive 
process, whereas they are only the representatives of real 
costs (efforts) and real benefits (satisfactions). We disen- 
tangle ourselves from the meshes of this money snare when 



Sec. 7] MUTUALLY RELATED PRICES 325 

we see that the controlling factors in determining prices are 
satisfactions on the demand side and efforts on the supply 
side. Between efforts and satisfactions there may be in- 
numerable intermediate stages, at each one of which supply 
and demand result in a market price ; but each such price 
represents simply anticipated satisfactions, or efforts trans- 
lated into money valuations. Any dealer at intermediate 
stages, between efforts preceding him and satisfactions fol- 
lowing after, has but little independent influence on price. 
He is like a link in a chain or a cogwheel in a machine, 
merely receiving and transmitting. If some real cost of 
production, earlier in the chain, i.e., some effort (or labor) 
is saved, he receives the cheapening effect from those of 
whom he buys, and passes it on to those to whom he sells. 
If some real benefit is reduced, i.e., some satisfaction di- 
minished, as by a change of fashion, he receives the cheapen- 
ing effect from those to whom he sells, and passes it back 
to those from whom he buys. The supply and demand of 
wheat in the Chicago wheat pit, for instance, is chiefly 
dependent on the labor of growing wheat and the satisfaction 
of eating bread. If a new labor-saving reaping machine 
is devised which reduces the actual effort of producing 
wheat, the effect is soon felt by the Chicago wheat dealer and 
transmitted to his customer. Or if people turn to a rice 
diet and no longer care much for bread, this effect is also 
soon felt by the Chicago dealer and passed back to the 
wheat producer. 

An intermediate dealer may not know the ultimate causes 
of the changes in supply and demand which affect his business 
on either side, and sometimes he does not try to think beyond 
what he immediately observes. Wholesale merchants gen- 
erally offer to their customers, the retailers, as an expla- 
nation of the rise in their charges, the fact that they have 
to pay higher prices to the jobber ; or, again, they may offer 
to the jobber as an explanation of the fact that they cannot 
pay as much as before, the fact that they cannot get as 



326 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

much from the retailers. Any such explanation of prices is 
shallow, for it goes no farther than explaining one price 
by another in the next link in the chain of prices. 

We see, then, that everything intermediate which happens 
in the economic machinery represents merely steps in the 
connection between effort and satisfaction. When Robinson 
Crusoe supplied his wants, there was a direct connection 
between his efforts in picking berries, for instance, and the 
satisfaction of eating them. To-day there are a number of 
links between these, but the same principle still applies. 
Supply and demand at intermediate points are all borrowed 
from efforts and satisfactions. 



CHAPTER XIX 

INTEREST AND MONEY 

§ i. The Importance of Interest 

We have seen that, in the last analysis, prices depend on 
comparisons between satisfactions, or efforts, or both. But, 
since these satisfactions and efforts are not all simultaneous, 
but are distributed in time, their comparison requires us to 
take account of interest. Consequently our study of prices 
will not be complete without a study of the rate of interest. 
It is only by means of the rate of interest, explicitly or im- 
plicitly employed, that the prices of most goods are reck- 
oned. The rate of interest, as previously explained, is it- 
self a sort of price. And it is by far the most important 
sort of price with which economics has to deal. 

Most people have an idea that the rate of interest is a 
technical Wall Street phenomenon, not concerning any one 
but money lenders or borrowers. This is partially true of 
explicit or contract interest. But there is implicit interest 
to be considered. An explicit rate of interest is the rate 
of interest explicitly stated in a contract. An implicit rate 
of interest is the rate of interest which an investor expects 
to realize who makes sacrifices at one time for the sake of 
compensating benefits at a later time. Implicit interest 
is also called profits. If we invest in a bond, for instance, 
the price that we pay carries with it the implication of a 
rate of interest we expect to realize on the investment. 
The implicit rate of interest, or the rate which we realize, 

327 



328 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIX 

is that rate of interest which, when used for discounting 
the income of the bond, will give the price at which we 
bought the bond. For instance, if a bond yielding $4 a 
year for 10 years, and then redeemable for $100, sells now 
for $105, we know the rate of interest realized is not four 
per cent, as it would be if it sold at par. It is less than four 
per cent — about 3.6 per cent. The implicit rate of in- 
terest we realize on such a bond may be found, as we have 
already seen, from a mathematical table. The man who 
buys the bond mentioned receives 3.6 per cent interest on 
his investment just as truly as though he had lent out his 
$105 at that rate. In fact, to buy a bond of a corpora- 
tion or a government is often spoken of as "lending 
money " to that corporation or government. Again the 
buyer of land who pays "twenty years' purchase" (for 
instance, $20,000 for land from which he expects an 
annual rental of $1000) is making five per cent just as 
though he were lending out his $20,000 at that rate. In 
the same way a man who buys stock realizes a certain per 
cent on his investment just as if he were lending money 
at interest. Similarly the purchaser of a house gets a 
return on the money he spent for it quite analogous to 
the return he would have received had he lent that money. 

In short, every investment is analogous to a loan and 
involves a rate of interest on the purchase price just as 
truly as does the loan. As every purchase is really an 
investment of present money for future benefits in money 
or measurable in money, every purchase price implies a 
rate of interest. A man cannot even buy a piano or an 
overcoat or a hat without discounting the value of the use 
which he expects to make of that particular article. The 
rate of interest, then, is not confined to Wall Street, but 
is something that touches the daily life of us all. 

How, then, is this important magnitude, the rate of 
interest, determined? The problem of interest is one of 
the most perplexing problems with which economic science 



Sec. 2] INTEREST AND MONEY 329 

has had to deal, and for two thousand years people have 
been trying to solve the riddle. 

§ 2. A Common Money Fallacy 

Among the earliest explanations of the rate of interest 
was that it is a payment simply for money, and that con- 
sequently it depends upon the quantity of money on the 
market. In particular, this theory of interest claims that 
plentiful money makes the rate of interest low. We 
commonly speak of interest as the " price of money," and 
the trade journals tell us that " money is easy " in Wall 
Street, meaning that interest is low, or that it is easy to 
borrow money. Or we are told that " the money market 
is tight," meaning that it is hard to borrow money. Prob- 
ably the great majority of unthinking business men believe 
that interest is low when money is plentiful, and high when 
money is scarce. We often hear the argument that the 
present high cost of living cannot be due to any plentiful- 
ness of money, because, if money were really plentiful, it 
would be cheap, meaning that the rate of interest would 
be low. 

The fallacy consists in forgetting that plentiful money 
raises the demand for loans just as much as it raises the 
supply, and therefore has just as much tendency to raise 
interest as to lower it. Suppose, for instance, a piano dealer 
wishes to stock up his store with pianos (the price of pianos 
being $200 apiece), and that he wishes to have a stock of 
50 pianos in his salesroom. To accomplish this he evidently 
will have to borrow $10,000. He goes to the bank and 
borrows it. Now, let us suppose that money becomes twice 
as abundant. This man, wanting to borrow again, will have 
an idea that in some way he will this time get a lower rate 
of interest at the bank, because, he reasons, the bank will 
have more money in its vaults and will be more anxious 
to lend it out. What he forgets is that the result of the 



330 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIX 

very abundance of money will be that prices in general 
will rise, and presumably the price of pianos in particular 
will rise ; therefore, in order to get 50 pianos, he will have 
to borrow twice as much money to enable him to pay for 
his pianos at the doubled prices. In order to buy 50 pianos, 
he will need $20,000 instead of $10,000. Likewise every 
other borrowing tradesman will need to borrow twice as 
much to conduct the same business. The fact that the 
banker has twice as much money to lend is therefore com- 
pletely offset by the fact that the borrowers will want to 
borrow twice as much. The consequence is that in the 
end doubling the amount of money will not affect the rate 
of interest. It will simply affect the amount of money 
lent and borrowed. 

We must remember that interest is not only the price 
of money, but it is the price in money. Interest is unlike 
any other price in that it is the price of money, but it 
is like all other prices in that it is the price in money. 
Thus the rate of interest is found by dividing $5 per year 
by $100. Both the numerator and the denominator of this 
fraction are expressed in terms of money. If we pay atten- 
tion only to the denominator, we are apt to think that an 
increased supply of money should decrease the rate of inter- 
est. But if we are to have a one-sided view, we might just 
as well fix our attention only on the numerator, and maintain 
that an increased quantity of money ought, instead of de- 
creasing the rate of interest, to increase it. The truth is, 
inflation of money works equally on both sides. In mechanics 
one of the first things we learn is that a man cannot raise 
himself by pulling up on his boot straps. The reason is that 
he is pulling himself down as much as up. The inflation of 
the currency pulls interest up on the demand side as hard 
as it pulls it down on the supply side. 

We should beware of the phrase " the price of money," 
for it has two meanings. It may mean the rate of interest, 
which is a ratio of exchange between two moneys — the 



Sec. 2] INTEREST AND MONEY 33 1 

price of money-capital in terms of money-income; or it 
may mean the purchasing power of money over other goods 
— the amount of other goods for which a given amount of 
money can be exchanged. The abundance of money will, 
as we have seen, reduce its price in the sense of purchasing 
power over goods, but it need not on that account reduce 
its price in the sense of the rate of interest. Yet the idea 
that the plentifulness of money tends to make interest 
low is a persistent one among business men. 

One reason for this idea is that bankers look upon money 
always in relation to their reserves, and if bank reserves 
are low, they have to raise the rate of interest to " protect " 
those reserves. If the reserves are abundant, bankers 
reduce the rate of interest in order to get rid of the reserve. 
The banker is constantly watching his reserve, and has to 
adjust the rate of interest with respect thereto. The only 
way to get rid of a plethora of money in the reserves is to 
lower the rate of interest, and the only way to protect a de- 
pleted reserve is to raise the rate of interest. But the banker 
should not measure the amount of money outside by the 
amount of money in his bank. What he forgets is that 
a larger reserve in his vaults does not necessarily mean 
more plentiful money ; nor when we have, as at present, 
for instance, a great quantity of money throughout the 
world, does this fact necessarily imply that Banker 
Smith will have more gold in his vaults. The money 
may get into the pockets of people first; it may in 
that way raise prices so high that the borrowers at 
banks may demand, for the reasons explained, larger loans. 
And yet, if for some reason a due share of the money does not 
at first flow into the banks, the result will be that Banker 
Smith will have too little reserve in relation to the greater 
loans that are now demanded of him. The consequence, 
then, will be actually to raise the rate of interest. When, 
therefore, the banker says that more money lowers the rate 
of interest, he ought to say, " When bank reserves get an 



332 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIX 

undue fraction of money, the rate of interest will be low; 
but when an undue fraction goes into circulation outside 
of banks, the rate of interest will be high." In other words, 
an increase of money will operate in two different ways, 
according to where it happens to go first. Normally and 
eventually, as we have seen in a previous chapter, an in- 
crease of money distributes itself between pockets, tills, 
and bank reserves, so as not to disturb the normal ratio 
between them. When this happens, the rate of interest 
will not be affected at all. 

This conclusion is not based merely on theory. As a 
matter of statistical fact, the rate of interest does not go 
up when money is scarce and down when money is abundant. 
For instance, an examination of the figures for per capita 
circulation of money in the United States for thirty-five 
years shows that in about half of the cases, when money grows 
more abundant, interest is higher, and in half of the cases 
it is lower. In other words, interest changes with abso- 
lutely no relation to the quantity of money in circulation. 

§ 3. Effect during Appreciation or Depreciation 

We conclude, then, that an inflation of the currency does 
not affect the rate of interest, provided, however, the inflation 
affects the loan at the time the loan is made just as much as 
it affects the repayment at the time the repayment is made. 
But the loan and the repayment do not occur at the same 
time; there is an interval of time between them, and it 
may be that the degree of inflation is greater or less at 
the end than at the beginning of this period, in which 
case the change in the inflation may, through its effect 
on the values borrowed and repaid, affect the rate of interest 
during the process of change. While inflation is taking place 
there is an effect on the rate of interest, because the effect 
of inflation on the sum loaned is different from the effect 
on the sum repaid. 



Sec. 3] INTEREST AND MONEY 333 

This brings us back to the consideration of the transition 
periods of rising and falling prices and discloses a phenome- 
non which we were not ready to discuss in Chapter X. This 
phenomenon is that the rate of interest tends to be high 
during a transition period when prices are rising from one 
level to a higher level and, reversely, that it tends to be low 
while prices are falling from one level to another. Suppose, 
for instance, that prices are rising at the rate of one per cent 
per annum. Then $100 lent to-day is equivalent in pur- 
chasing power, not to $100 repayable next year, but to $101 
repayable next year. If prices had not risen, the borrower 
would have had to pay back, as his principal, $100, and this 
would have meant the same amount of goods as were 
represented by the $100 when he borrowed it. In terms 
of goods he would have been in the same position at the 
end as at the beginning, and so would the lender. But we 
are supposing that prices are rising. Then the lender, if 
he gets back as his principal only $100, does not get back 
as much purchasing power as he lent, and the borrower 
does not pay back as much purchasing power as he borrowed. 
In other words, the fact that prices have risen during the year 
has made it easy for the borrower and hard for the lender. 
During the Civil War the United States government issued 
a great many " greenbacks." The result was an inflation 
of the currency and a consequent rise of prices, and the 
result of that was that men who had mortgaged their farms 
in the West found it very easy to pay back their loans. 
As they said, the mortgages on their farms "disappeared like 
smoke." Five thousand dollars paid back in 1864 for $5000 
loaned in i860 really only represented half as much purchas- 
ing power over goods, for prices had doubled ; the inflation 
of the currency freed the borrowers from half their debts. 

We see, then, that when prices are rising, the principal 
of a debt becomes less and less valuable. If prices are rising 
one per cent, i.e., the principal of the debt, in terms of 
goods, falling about one per cent, then the interest on the 



334 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIX 

debt ought to be increased about one per cent in order 
that there should be exactly the same burden on the 
borrower in paying back as there would have been if prices 
had not risen. If prices are rising two per cent per annum, 
two per cent would have to be added to the rate of in- 
terest in order to compensate for the rise ; and so on for 
other rates of rise in prices. On the other hand, if prices 
are falling, we must reduce the rate of interest to offset 
the appreciation of the principal. 

This ideal compensation in the rate of interest would oc- 
cur if man's foresight were perfect. If we knew absolutely, 
for instance, that next year's prices were going to be two 
per cent higher than this year's, the rate of interest would 
be two per cent greater than otherwise. So, also, if we 
knew absolutely that all prices would be one per cent less a 
year from to-day, than to-day, the rate of interest during the 
year would be, on that account, one per cent less than other- 
wise. But we never know the future exactly ; we can only 
guess. Consequently, lenders and borrowers do not make 
perfect compensation. The facts show that the general 
sentiment is that prices probably will neither rise nor fall. 
People are apparently reluctant to believe that prices are 
going to change very much in either direction. The re- 
sult of this inadequacy of foresight is that, when prices are 
rising, the rate of interest is usually high, but not so high 
as it should be to make a perfect compensation for the 
rise ; and that, on the other hand, when prices are falling, 
the rate of interest is usually low, but not so low as it should 
be to make a perfect compensation for the fall. Thus the 
rate of interest, though partially adjusted during transition 
periods, is not sufficiently adjusted to alter the essential 
fact emphasized in Chapter X ; namely, that during rising 
prices the burden of debts grows lighter on borrowers, and 
that, consequently, "enterpriser borrowers " tend to be pros- 
perous ; while, reversely, when prices are falling, the same 
people lose, and business is dull. 



SEC. 4] INTEREST AND MONEY 335 

A study of the periods of rising and falling prices in the 
United States, England, Germany, France, China, Japan, 
and India verifies these principles. It shows that, in gen- 
eral, when prices are rising, the rate of interest is high, and 
when prices are falling, it is low. 

§ 4. Effect of Unequal Foresight 

Certain important aspects of these tendencies are con- 
nected with the fact that during rising or falling prices some 
individuals make more allowance than do others for these 
changes, according to their several degrees of foresight. 
Different persons differ greatly in their power to foresee. 
In general, borrowers foresee better than lenders. The great 
borrowers of to-day are not the ignorant poor, but the alert 
and well-informed rich. It is the function of these people 
to look ahead, and the consequence is that they foresee a 
rise or fall of prices more quickly than the lenders or bond- 
holders, who are only silent partners in business. Now, a 
consequence of the superiority in foresight of borrowers 
over lenders is that the borrowers are willing, during rising 
prices, to pay a higher rate than they have to pay, whereas 
the lenders do not see any reason for raising the rate of 
interest. Suppose that the rate of interest, on a basis of 
stationary prices, is five per cent, and that prices are rising 
two per cent per annum. We know that the rate of interest 
ought to be seven per cent in order to make things even ; 
but let us suppose that the borrowers foresee that prices are 
going to rise two per cent per annum, and that they are per- 
fectly willing to pay seven per cent, where otherwise they 
would pay five per cent. Let us suppose, also, that the 
lenders are not alert enough to see why interest should be 
any more than five per cent. The consequence will be that 
the rate of interest will not rise as high as seven per cent, but 
will be something like six per cent. The consequence of this, 
in turn, is that the borrowers, who are willing to pay seven 



336 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIX 

per cent to get the same loans that they used to get at five 
per cent, when they find that they do not have to pay seven 
per cent, but can get loans at six per cent, will increase 
the size of their loans. Thus borrowers are encouraged 
to borrow more. Likewise lenders are encouraged to lend 
more, for they find that they can get six per cent when they 
are willing to take five per cent. This six per cent is low 
in the eyes of the borrowers, but high in the eyes of the 
lenders. The consequence, therefore, is an inflation of 
loans stimulated from both sides of the market. 

In a previous chapter we saw that an increase of loans 
of banks makes an increase of deposits, inflates the currency, 
and makes prices rise further, and so on around the circle of 
inflation, loans, deposits, and inflation again. The circular 
process has to come to a stop sometime, but it never does 
come to a stop until the rate of interest is adjusted. As long 
as the rate of interest still stays too low, borrowing will 
continue too high. Presently people wake up to the danger 
of this condition of inflated loans and deposits, the rate of 
interest does go up, discouraging loans and precipitating 
a crisis. Then we have the back-flow : prices decreasing, 
interest falling, and a discouragement of business. This 
has all been explained in a previous chapter. What needs 
emphasis here is that the essential difficulty in all these 
changes is with the rate of interest. The rate of interest is 
the key to the situation. Were the rate of interest properly 
adjusted, there would be less trouble, if, indeed, there were 
any at all. Crises would be fewer, and they would be less 
severe. 

How, then, can we get a better adjustment of the rate of 
interest? One way is to prevent these changes in price 
levels as much as possible. This we have already discussed. 
Another is to have men more alive to the future and more 
quick to predict what is going to happen to prices. Edu- 
cation on this line will go on and is going on through the 
trade journals. Still another way is through the removal 



Sec. 4] INTEREST AND MONEY 337 

of the existing prejudice against raising the rate of interest. 
We still inherit the old idea that interest is " usury " or 
robbery. If we could once get rid of the prejudice against 
allowing the rate of interest to rise high as well as to fall 
low, that is, could regard the rate of interest as properly 
subject to fluctuation and as being a market price changing 
day by day, like any other price, a long step would be taken 
toward preventing crises. 



CHAPTER XX 

IMPATIENCE FOR INCOME THE BASIS OF INTEREST 

§ i. The Productivity Theory 

In the preceding chapter we have considered the relation 
of money to the rate of interest. We saw that the money 
supply has no effect on the rate of interest, except during 
transition periods. The real riddle of interest, therefore, still 
remains unsolved. Why is there such a thing as a rate of 
interest, even when the purchasing power of money is con- 
stant, and what, then, determines that rate ? What other 
factors besides inflation or contraction of the currency affect 
the rate of interest? We must now go back of money and 
study the supply and demand of loans. 

In our study of prices we began by considering first the 
part played by money, and then undertook an analysis of 
supply and demand of goods. We are following the same 
order in our study of that peculiar price called the rate of 
interest. We have thus far considered only the part played 
by money, and now are ready to undertake an analysis of 
the supply and demand of loans. We shall find that, con- 
trasted with the supply and demand of goods, which resolves 
itself in the last analysis into a comparison between dif- 
ferent marginal desirabilities and undesirabilities, which are 
simultaneous, the supply and demand of loans resolves itself 
in the last analysis into a comparison between different mar- 
ginal desirabilities and undesirabilities, which are not simul- 
taneous, but are distributed at different points in time. 

338 



Sec. i) THE BASIS OF INTEREST 339 

Before, however, we can fully justify these propositions, 
we shall need to clear the way by removing some of the many 
fallacies and pitfalls which surround the subject. 

There is, perhaps, no other " nut " so hard to " crack " 
in all economics as this one of the rate of interest. Before 
most persons have grown old enough to consider the sub- 
ject philosophically, they have absorbed, more or less un- 
consciously, a number of untenable and conflicting theories. 

Next to the money fallacies which were considered in the 
last chapter, one of the most persistent fallacies is that 
" interest is due to the productivity of capital." If a man 
who has never thought on the subject is asked why the rate 
of interest is five per cent, he will almost invariably answer, 
" because five per cent is what investments pay." If you 
have $100 and invest it, and it yields you five per cent 
a year, the rate of interest is five per cent. A $100,000 mill 
will produce a net income of $5000 a year; a $100,000 
piece of land will produce a net crop worth $5000 a year ; 
and so on throughout the whole series of investments. When 
the rate of interest is five per cent, nothing at first sight seems 
more obvious than that it is five per cent because capital 
yields five per cent. Since capital is productive, it seems 
self-evident that an investment of $100 in productive land, 
machinery, or any other form of capital will yield a rate 
of interest proportionate to its productivity. This proposi- 
tion looks attractive, but it is superficial. Why is the land 
worth $100,000? Simply because this is the discounted 
value of the expected $5000 a year. We have seen in pre- 
vious chapters that the value of capital is derived from the 
value of its income, not the value of the income from that of 
the capital. But whenever we discount income, we have 
to assume a rate of interest. One hundred thousand dollars 
is a capitalization calculated on the basis of five per cent 
interest. If we capitalize an income of $5000 at five per 
cent, and get $100,000, we naturally find that we are getting 
five per cent on the investment, for we assumed five per cent 



34° ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XX 

in the first place. We find at the end exactly what we as- 
sumed at the beginning; but if we are not careful, we 
delude ourselves into thinking that we are finding something 
new. 

It is evident that if an orchard of ten acres yields ioo 
barrels of apples a year, the physical-productivity, 10 
barrels per acre, does not of itself give any clew to what 
rate of return on its value the orchard yields. 

The orchard produces the apples, but the value of the 
orchard does not produce the value of the apples; on the 
contrary, the value of the apples produces the value of the 
orchard. 

The following diagram shows the typical relation between 
capital and the productivity of capital in the physical sense 
and also in the sense of value-return — which latter is the 
important factor in studying the rate of interest. 

Present Capital Future Income 

Instruments *- Benefits 

\ 

Value of instruments -^ Value of benefits 

This scheme signifies that (i) any instrument, such, for 
instance, as land, railways, factories, dwellings, or food, is 
the means for obtaining benefits of some kind. This first 
step in the sequence pertains to the study of the " tech- 
nique " of production, and involves no rate of interest. 
(2) The benefits are valued in money. This step pertains 
to the study of prices. (3) From the value of the benefits 
thus obtained is computed the value of the original instru- 
ment by the process of discounting. It is clearly with this 
last process that we are concerned in the study of interest. 

The paradox that, when we come to the value of capital, it 
is income which produces the value of capital, and not the 
reverse, is, then, the stumbling-block of the productivity 
theorists. It is clear, of course, in any particular investment, 
that the selling value of the stock or bond is dependent on 



Sec. i] THE BASIS OF INTEREST 341 

its expected income. And yet business men, although con- 
stantly employing this discount process in specific cases, usu- 
ally cherish the illusion that they do so because their capital- 
value in some vague " other use " actually produces interest. 
They fail to observe that the principle of discounting the 
future is universal, and applies to any investment whatso- 
ever, and that in such a discount-process there is neces- 
sarily assumed the very rate of interest we are seeking to 
explain. It is futile to derive the rate of interest from the 
productivity of capital. 

The futility of this productivity theory may be further 
illustrated by observing the effect of a change of productivity. 
If productivity makes interest, then a change in produc- 
tivity ought to make a corresponding change in the rate 
of interest. Yet, if an orchard could in some way be 
made to yield double its original crop, though its yield in 
the physical sense would be doubled, in the sense of the 
rate of interest its yield would not be necessarily 
affected at all — certainly not doubled. For the orchard 
whose yield of apples should increase from $1000 worth 
to $2000 worth would itself correspondingly increase in 
value. For some reason or other, people would find 
themselves calling it a $40,000 orchard instead of a $20,000 
orchard ; and the ratio of the income to the capital- 
value would then remain as before, namely, five per cent. 
Of course it is true that if an orchard which had been bought 
for $20,000 on the assumption that it would yield only $1000 
worth of crops per year should in some way be doubled 
in productivity, the owner would be making ten per cent 
on his original investment, for his original investment was 
made before he knew that the orchard would increase in 
productivity. Had he known this fact in advance, he 
would have been willing to pay more than the $20,000 which 
we have supposed him to pay. As soon as this new knowl- 
edge is acquired, he will revalue the orchard according to 
his new expectations. Realizations do not always or even 



342 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XX 

usually correspond to expectations. Properly speaking, the 
rate of interest applies only to expectations. It represents 
the premium paid for present goods in terms of future 
expected goods. Whether these future goods will actually 
be as expected is another matter. 

To raise the rate of interest by increasing the productivity 
of capital is, therefore, like trying to raise one's self by one's 
boot straps. Nor can this conclusion be escaped (as has 
sometimes been attempted) by supposing the increasing 
productivity to be universal. It has been asserted, in 
substance, that though an increase in the productivity 
of one orchard would not appreciably affect the total pro- 
ductivity of capital, and hence would not appreciably 
affect the rate of interest, yet if the productivity of all the 
capital of the world could be doubled, the rate of interest 
would be doubled. Now, doubling the productivity of the 
world's capital would not be entirely without effect upon 
the rate of interest; but the effect would not be in the 
simple direct ratio supposed. Indeed, an increase of the 
productivity of capital would probably result in a decrease, 
instead of an increase, of the rate of interest. To double 
the productivity of capital might more than double the 
value of the capital ; at least, that it would fail to do so 
has not been shown by the productivity theorists, much less 
that capital would remain unchanged in value. And if it 
doubled in value, we should have the same result as before. 

§ 2. The Socialist's Theory 

So much for the productivity theory. We have next the 
socialist's theory. The socialist has the idea that interest 
is robbery. He says " it is all wrong that the capitalist who 
does not lift a finger should get any pay; he is getting 
something for nothing, and that is interest; interest is 
robbery; interest is sucking the blood out of somebody 
else, viz., the workman." According to the socialist theory, 



Sec. 2] THE BASIS OF INTEREST 343 

especially as represented by Karl Marx, interest is exploi- 
tation ; it is payment which, for some reason, never satis- 
factorily explained, is made to the rich who sit by and do 
nothing, while somebody else produces all the tribute that 
has to be poured into their laps. The socialists say that 
labor produces capital, and therefore produces the interest 
from capital, and therefore labor should get all the income 
from capital ; and since the laborer does not get it all, it 
must be held back by somebody who is in a position of 
vantage to steal it. This is the key of so-called " scientific 
socialism." There are many motives for socialism, but so 
far as it has an economic theory behind it, this is the theory. 
The capitalist, these socialists believe, holds a club over the 
workman and virtually says : "If you will come to-day and 
work for me, I will give you half of what you produce ; I 
have got the capital, and you can't get on without me, and 
therefore I am in a position to rob you. Yield, or I'll 
not let you have anything." 

The socialist's position involves two propositions : first, 
that all income and all capital are practically produced by 
labor ; and, secondly, that all the income should be paid 
to the laborer. Now the first proposition is much more 
nearly correct than the second. We need not contest it in 
order to see the fundamental error in the theory of socialism. 
Let it be granted that practically every instrument of pro- 
duction is produced by labor; let it be granted that the 
capitalist is always living on the product of past labor ; 
that a millionaire who gets his income from railroads, ships, 
and houses, all products of labor, is reaping what labor 
sowed ; that the capitalists of to-day are receiving compound 
interest on the labor of the past. 

It does not follow, however, that injustice has been done 
to the laborer. Let us consider the case of a tree which is 
planted with one dollar's worth of labor, and twenty-five 
years later is worth three dollars. The socialist virtually 
asks, "Why should not the laborer who planted the tree 



344 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XX 

receive three dollars instead of one dollar for his work? " 
The answer is that he may receive it, provided he will wait 
twenty-five years for it ! As Bohm-Bawerk, an authority 
on interest, says : " The perfectly just proposition that the 
laborer should receive the entire value of his product may 
be understood to mean either that the laborer should now 
receive the entire present value of his product, or should 
receive the entire future value of his product in the future. 
But Rodbertus and the socialists expound it as if it meant 
that the laborer should now receive the entire future value 
of his product." 

It would be a mistake to say that there is no exploitation 
of laboring men by capitalists, because we know the contrary 
to be a fact, but it is absurd to condemn all interest on the 
ground of exploitation. The basis of interest is much deeper. 
It lies in the preference for present over future goods. It is 
because the laboring man cannot wait that he is willing to 
take something less than the whole value, and it is right that 
he should do so, because the capitalist does not like to wait 
either, and the capitalist is really taking a burden off of the 
laborer when he pays him in advance for planting a tree and 
waits himself twenty-five years before getting the product. 

§ 3. Impatience the Source of Interest 

The essence of interest is impatience, the desire to obtain 
gratifications earlier than we can get them, the preference for 
present over future goods. This preference comes from a 
fundamental attribute of human nature. As long as people 
like to have things to-day rather than to-morrow, there will 
be a rate of interest. 

Interest is, as it were, impatience crystallized into a market 
rate. The rate of interest is formed out of the various de- 
grees or rates of impatience in the minds of different people. 
The rate of impatience in any individual's mind is his pref- 
erence for an additional dollar, or one dollar's worth of goods, 



Sec. 3] THE BASIS OF INTEREST 345 

available to-day, over an additional dollar, or dollar's worth 
of goods, available a year from to-day. In other words, it 
is the excess of the marginal desirability of to-day's money 
over the marginal desirability of next year's money viewed 
from to-day's standpoint. It can be expressed in numbers 
as the premium that a man is willing to pay for this year's 
over next year's money. If, for instance, in order to get $i 
to-day he is willing to promise to pay $1.05 next year, then 
his rate of impatience is five per cent. The present $i is 
worth to him so much that in order to get it he is willing 
to pay five per cent more than $i in the future for it ; it 
is the willingness to do this to gratify one's impatience which 
causes the phenomenon of a rate of interest. A man will 
prefer to have a machine to-day rather than a machine in 
the future ; a house to-day rather than a house a year from 
now ; a piece of land to-day rather than a piece of land when 
he is ten years older ; he would rather have some food to-day 
than wait until next year for it, or a suit of clothes, or stocks 
or bonds, or anything else. 

But what are these present and future " goods " which are 
thus contrasted? At first sight it might seem that the 
" goods " compared may be indiscriminately wealth, prop- 
erty, or benefits. But when present capital (whether 
capital-wealth or capital-property) is preferred to future 
capital, this preference is really a preference for the income 
of the first capital as compared with the incomeoi the second. 
The reason we would choose a present fruit tree rather than 
a similar fruit tree available in ten years is that the fruit 
of the first will be available earlier than that of the second. 
The reason we prefer immediate tenancy of a ihouse to the 
right to occupy it in six months is that the uses of the 
house will begin six months earlier in the one case than in 
the other. In short, capital-wealth available early is pre- 
ferred to capital-wealth of like kind available at a more 
remote time, simply because the income of the former is 
available earlier than the income of the latter. For the 



346 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XX 

same reason, early capital-property is preferred to late 
capital-property of a similar kind ; for property is merely 
a claim to future income ; and the earlier the property is 
acquired, the earlier will the income accrue, the right to 
which constitutes the property in question. 

Thus, all rates of impatience resolve themselves into pref- 
erence for immediate income over remote income. Moreover, 
the preference for present income over future income resolves 
itself into the preference for present enjoyable income over 
future enjoyable income. The income from an article of 
capital which consists merely of an " interaction " is desired 
for the sake of the final income to which that interaction 
paves the way. We prefer present bread-baking to future 
bread-baking because the enjoyment of the resulting bread 
is available earlier in the one case than in the other. 
Present weaving is preferred to future weaving, because 
the earlier the weaving takes place, the sooner will the cloth 
be manufactured, and the sooner will the clothing made 
from it be worn by the consumer. 

When, as is usually the case, exchange intervenes between 
the weaving and the use of the clothes, the goal in the process 
is somewhat obscured by the fact that the manufacturer 
regards his preference for present weaving over future 
weaving as due not to the fact that the clothes will be more 
early available to those who will wear them, but to the fact 
that he will be enabled to obtain a quicker income by selling 
the cloth earlier. To him early sales are more advantageous 
than deferred sales, because the earlier the money is re- 
ceived, the earlier can he spend it for his own personal uses, 
— the shelter and the comforts of various kinds constituting 
his real income. It is not he, but his customers, whose 
preference for present cloth over future cloth is based on 
the earlier availability of the clothes which can be made 
from it. But in both cases the mind's eye is fixed on some 
ultimate enjoyable income, i.e., benefits, to which the in- 
teraction in question is a mere preparatory step. 



Sec. 3] THE BASIS OF INTEREST 347 

The same principles apply where corporations or firms 
borrow and lend. Here the relation of enjoyable income 
is more indirect, and yet it is still the guiding force. For 
borrowing and lending, when directed by the directors of 
a company as agents for the stockholders or bondholders, 
have reference to the enjoyable income, not of the directors, 
but of the stockholders and bondholders. As we know, 
final enjoyable income consists of satisfactions. 

We thus see that all preference for present over future 
goods resolves itself, in the last analysis, into a preference 
for early enjoyable income over late enjoyable income. Every 
preference for present over future goods reduces itself, there- 
fore, to this preference for present over future satisfactions. 

The preference for present over future goods, when thus 
reduced to its lowest terms, rids the values of the contrasted 
present and future goods of the interest element, which, 
in all other attempts at explanation, is so unconsciously 
presupposed. When any other goods than enjoyable in- 
come are considered, their values already imply a rate of 
interest. When, for instance, we say that interest is the 
premium on the value of a present house over that of a 
future house, we still leave the problem of interest un- 
solved ; for we forget that the value of each house is itself 
based on a rate of interest. As we have seen, the price of 
a house is the discounted value of its future income, and 
in the process of discounting there always lurks a rate of 
interest. Hence, when we compare the values of present 
and future houses, both terms of the comparison involve 
the rate of interest. But when present ultimate income is 
compared with future ultimate income, the case is differ- 
ent, for the value of ultimate income involves no interest 
whatever. 

We have thus reduced the problem of determining the 
rate of interest to the problem of determining the premium 
which people are willing to pay for present enjoyable 
income in terms of future enjoyable income. 



CHAPTER XXI 

INFLUENCES ON IMPATIENCE FOR INCOME 

§ i. Influence which Differences in Human Nature 
Exert on the Rate of Impatience 

But we have not yet wholly solved the problem of interest. 
It is not enough to know that the more impatient a people 
are, the higher will be their rate of interest, and the more 
patient they are, the lower will be their rate of interest. 
We must also know on what causes the rate of impatience 
depends. It depends principally upon the character of 
the individual and the character of the income which he 
possesses. It is clear that the rate of impatience which 
corresponds to a specific income-stream will not be the same 
for everybody. One man may have a rate of impatience 
of five per cent and another a rate of impatience of ten per 
cent, although both have the same income. The difference 
will be due to a difference in the personal characteristics 
of the individuals. These characteristics are chiefly five 
in number : (i) foresight, (2) self-control, (3) habit, (4) ex- 
pectation of life, (5) love for posterity. We shall take these 
up in order. 

(1) First, as to foresight. Generally speaking, the greater 
the foresight, the less the rate of impatience, and vice versa. 
In the case of primitive races and uninstructed classes 
of society, the future is seldom considered in its true pro- 
portions. The story is told of a Southern negro that he 
would not mend his leaky roof when it was raining, for fear of 

348 



Sec. i] INFLUENCES ON IMPATIENCE FOR INCOME 349 

getting more wet, nor when it was not raining, because he 
did not then need shelter. Among such persons the rate 
of impatience for present gratification is powerful because 
their comprehension of the future is weak. If we compare 
the Scotch and the Irish, we shall find a contrast in this 
respect. The Irish, in general, lack foresight and are im- 
provident, and the Scotch have foresight and are provident. 
Consequently the rate of interest is high in Ireland and 
low in Scotland. 

These differences in degrees of foresight produce corre- 
sponding differences in the dependence of impatience on 
the character of income. Thus, for a given income, say 
$1000 a year, the reckless might have a rate of impatience of 
ten per cent, when the forehanded would experience a rate 
of only five per cent. Therefore, the rate of impatience, in 
general, will be higher in a community consisting of reck- 
less individuals than in one consisting of the opposite type. 

(2) We come next to self-control. This trait, though 
distinct from foresight, is usually associated with it and has 
very similar effects. Foresight has to do with thinking, self- 
control with willing. A weak will usually goes with a weak 
intellect, though not necessarily, and not always. The 
effect of a weak will is similar to the effect of inferior fore- 
sight. Like those workingmen who cannot carry their 
pay home Saturday night, but spend it in a grogshop on the 
way, many persons cannot deny themselves any present 
indulgence, even when they know definitely what the con- 
sequences will be in the future. Others, on the contrary, 
have no difficulty in controlling themselves in the face of 
all temptations. 

(3) The third characteristic of human nature which needs 
to be considered is habit. That to whic 1 - one is accustomed 
exerts necessarily a powerful influence upon his valuations 
and therefore upon his rate of impatience. This influence 
may be in either direction. A rich man's son who has been 
brought up in habits of self-indulgence, when he finds him- 



350 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 

self with a smaller income than his father provided him 
during his formative years, will have a higher rate of im- 
patience than a man who has this same income but who 
has climbed up instead of climbed down. 

(4) The expectation of life will affect a man's rate of im- 
patience. A man who looks forward to a long life will have 
a relatively high appreciation of the future, which means 
a relatively low appreciation of the present, i.e., a low rate of 
impatience; whereas a man who has a short life to look 
forward to will want it at least to be a merry one. " Eat, 
drink, and be merry, for to-morrow we die " is the motto 
applying to this type. 

(5) The fifth circumstance is love for posterity. Prob- 
ably the most powerful cause tending to reduce the rate of 
interest is love for one's children and the desire to provide 
for their good. When these sentiments decay, as they did 
decay at the time of the decline and fall of the Roman 
Empire, and it becomes the fashion to exhaust wealth in 
self-indulgence and leave little or nothing to offspring, the 
rate of impatience and the rate of interest will be high. 
At such times the motto, " After us the deluge," indicates 
the feverish desire to squander in the present, at whatever 
cost to the future. A noted gambler, who had led a wild 
and selfish life, once said, when life insurance was first 
explained to him, " I have seen many schemes for making 
money, but this is the first time I have seen a scheme where 
you had to die before you could rake in the pile." That 
man did not care for a payment which would come in after 
his death. But there are many men who do, and in fact 
care much more for it than for anything else in the world. 
This care leads them to insure their lives in order that they 
may leave the money to their families. Their desire to 
provide for those who survive them gives them a low rate of 
impatience. Life insurance, by training people to provide 
for posterity, is acting as one of the most powerful means of 
lowering the rate of impatience and therefore the rate of 



Sec. i] INFLUENCES ON IMPATIENCE FOR INCOME 351 

interest. At present in the United States the insurance 
on lives amounts to $20,000,000,000. This represents, for 
the most part, an investment of the present generation 
for the next. The investment of this sum springs out of 
a low rate of impatience, and tends to produce a low rate 
of interest. 

Thus we see that men may differ in many ways which 
affect the rate of interest and the rate of impatience. We 
may contrast two extreme types of men. Men may have 
a high rate under the following conditions : if (irrespective 
of the character of their income) they are shortsighted, or 
are weak willed, or have the habits of a spendthrift, or look 
forward to a short or uncertain life, or are selfish and have 
no regard for posterity. The opposite characteristics will 
lead to a low rate of impatience : foresight, self-control, 
habits of thrift, confidence in length of life, and altruism 
with respect to posterity. 

But not only does impatience vary as between different 
individuals ; it varies also for the same individual according 
to circumstances. The most important circumstance affect- 
ing a person's degree of impatience is the character of his 
expected income in the immediate and in the remote future. 
One's impatience for satisfactions will vary inversely as 
the amount of his present as compared with his future 
satisfactions. If the future satisfactions which he expects 
and looks forward to are very great, and his present satis- 
factions are very small, he will be impatient to hurry from 
his present scarcity and arrive at the expected future abun- 
dance; that is, he will have a high rate of preference 
for present over future satisfactions. This is on the same 
principle that prices are high when goods are scarce. The 
preference for present satisfactions is high if present satis- 
factions are scarce. Now the rate of preference which one 
has for present satisfactions over future satisfactions will 
depend on one's whole future stream of satisfactions, i.e., 
what we call his final enjoyable income. It will depend 



352 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XXI 

on three chief characteristics of that income : first, as just 
said, it will depend on the distribution in time of the income 
or what we may call its time-shape, i.e., the relative abun- 
dance of his present as compared with his future satisfac- 
tions; second, on the amount of the income, i.e., whether 
his satisfactions are few or many; third, on the uncer- 
tainties of the income, i.e., to what extent his satisfactions 
throughout future years can be depended upon. 

We see, then, that a man's rate of impatience depends (i) 
upon his nature, and (2) upon his income. In the following 
illustrative table we see contrasted the supposed extreme 
types of income and of human nature, and see how the 
rate of impatience will depend upon the various combina- 
tions involved. 



Description of Income 


Corresponding Rate of Impatience 
to an Individual who is 








Short-sighted, weak- 
willed, accustomed 
to spend, without 
heirs 


Far-sighted, self -con- 
trolled, accustomed to 
save, desirous to pro- 
vide for heirs 


Small 
Large 


Increasing 
Decreasing 


Precarious 
Assured 


20% 

5% 


5% 
1% 



If we compare the figures in the same vertical column, we 
see that the lower figure is the smaller, expressing the in- 
fluence of the character of income. If we compare the figures 
in the same horizontal line, we see that the right-hand figure 
is the smaller, expressing the influence of human nature. 
But a man may have an income-stream of a kind which 
tends to make a high rate of impatience, and at the same 
time a nature of a kind which tends to make a low rate of 
impatience. The result will then be a compromise rate 
of impatience, say five per cent. Or a man may have an 
income-stream which tends to make his rate of impatience 



Sec. 2] INFLUENCES ON IMPATIENCE FOR INCOME 



353 



low, and a nature which tends to make the rate of impatience 
high. Thus five per cent is found twice in the table forming 
a diagonal. The other diagonal shows the contrast between 
the extreme where both the character of the income and the 
nature of the individual conspire to make a very high rate 
of impatience, and the opposite extreme where they con- 
spire to make a very low rate of impatience. 

The rate of impatience of any individual depends, then, 
partly on the character of that individual's income, i.e., on 
three characteristics of income : — 

(1) its time-shape, 

(2) its amount, 

(3) its uncertainties. 

This proposition — that the preference of any individual 
for present over future income depends upon the nature 
of his prospective enjoyable income — corresponds to the 
proposition in the theory of prices, that the marginal desir- 
ability of any article depends upon the quantity of that 
article ; both propositions are fundamental in their respec- 
tive spheres. 

§ 2. Influence of the Time-shape of the Income-stream 



We have first 
to consider the 
influence of the 
time-shape of 
income, i.e., the 
distribution of 
income in time, 
upon the rate 
of impatience. 
Three different 
types of time- 
shape may be 
distinguished: 

2A 



2600 

24O0 

22O0 

2000 

1800 

1600 

I400 

1200 

IOOO 

800 

600 

400 

200 






1910 II 



12 



T3 

Fig. 



14 

41. 



\S '16 '17 



354 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 



uniform income, consisting of equal yearly items, as repre- 
sented by the dark lines in Figure 41 (in which, as in 

previous dia- 
grams the 
heights of the 
successive verti- 
cal lines represent 
the amounts of 
the successive in- 
stallments of in- 
come, say $1900 
a year) ; increas- 
ing income, as 
represented in 
Figure 42 (in 
which the income 
is supposed to 
increase from 



3000 

2600 

2600 

S400 

2200 

2000 

1800 

1600 

«400 

I200 

IO00 

800 

600 

400 

200 



























1 






' 














































































































































































































































































































































































- 

















































































































4910 I! '12 



'15 '16 '17 



'13 '14 

Fig. 42. 

$1200 a year in 
191 1 to nearly $3000 in 191 7) ; and decreasing income, as 
represented in j. 
Figure 43 (in 3ooo 
which the income asoo 
is supposed to de- 2600 
crease from al- 
most $3000 in 
191 1 to about 
$1200 in 1917). 
The effect of 
possessing an in- 
creasing income 
(Fig. 42) is, as we 
have already in- 
dicated, to make 

the possessor im- , 9l0 '11 'is '13 '14 
patient, i.e., to fig. 43. 



2400 
2200 
2000 
1800 
i6oq 

!400 

1200 
1000 
800 
600 
400 
200 



1 



'15 '16 '17 



Sec. 3] INFLUENCES ON IMPATIENCE FOR INCOME 355 

make his preference for present over future income higher 
than otherwise; for it means .that the earlier parts of 
his income are relatively scarce, and the remoter parts of 
his income, relatively abundant. A man who is now enjoy- 
ing an income of only $1000 a year, but expects in ten years 
to be enjoying one of $10,000 a year, will be impatient to 
have those ten years elapse. He has " great expectations." 
He may, to satisfy his impatience, borrow money to eke out 
this year's income, and make repayment by sacrificing from 
his more abundant income ten years later. 

Reversely, a gradually decreasing income (Fig. 43), mak- 
ing, as it does, the earlier income relatively abundant, and 
the remoter income relatively scarce, tends to reduce impa- 
tience, or the preference for present as compared with future 
income. The man with a descending income already has 
a high income without being compelled to wait for it. With 
him there is little reason for impatience — there is nothing 
to be impatient for ; on the contrary, the future does not 
look at all inviting. The outlook, so far from tending to 
make him borrow, tends to make him wish to save from 
his present abundance to provide for his coming need. 

The extent of these effects will, as we have already seen, 
vary greatly with different individuals. Corresponding to 
a given ascending income, one individual may have a rate 
of impatience of ten per cent and another of only four per 
cent. What we need here to emphasize is merely that, in the 
case of both of these individuals, a descending income causes 
a lower rate of impatience than an ascending income. 

§ 3. Influence of the Size of the Income-stream 

So much for the time-shape of a man's income, or its 
distribution in time. Our next topic is the dependence of 
impatience on the size of income. In general, it may 
be said that the smaller the income a man has, the higher is 
his preference for present over future income. It is true 



356 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 

that a small income implies a keen appreciation of future 
wants as well as of immediate wants. Poverty bears down 
heavily on all parts of a man's life, both that which is 
immediate and that which is remote. But it enhances the 
desirability of immediate income even more than of future 
income. 

This result is partly rational, because of the importance 
of supplying present needs, in order to keep up the con- 
tinuity of life and the ability to cope with the future ; and 
partly irrational, because the pressure of present needs 
blinds one to the needs of the future. 

As to the rational side, it is clear that present income is 
absolutely indispensable, not only for the present, but even 
as a precondition to the attainment of future income. One 
break in the thread of life is sufficient to destroy all future 
enjoyment. It is of the utmost importance, therefore, to 
keep up life. As the phrase is, " a man must live," and in 
the present a man must keep his hold on life in order to have 
any life in the future. If, then, a man were on a desert 
island and had only such rations as would last a few months, 
he would naturally prefer to use them immediately — 
sparingly, but immediately — rather than to put off their con- 
sumption ten years ; because if he put off consuming them 
he could not consume them at all ; he would die in the mean- 
time. And in general, a man who is poor, and upon whom 
poverty presses so as to make it hard to make both ends 
meet, will always have a higher realization and apprecia- 
tion of the present than a man who is rich. 

As to the irrational side, the poorer a man, the more his 
eyes are blinded to future needs. He is too much occupied 
with the need of the present, and shuts his eyes to the 
future. To him " sufficient unto the day is the evil thereof." 
We all suffer from lack of perspective, and tend to exaggerate 
the needs of the present. Poverty especially tends to distort 
the perspective. Its effect is to relax foresight and self- 
control, and tempt one to " trust to luck " for the future, 



Sec. 4] INFLUENCES ON IMPATIENCE FOR INCOME 357 

if only the all-absorbing clamor of present necessities may 
thus be satisfied. 

We see, then, that a small income tends to produce a 
high degree of impatience, partly from lack of foresight 
and self-control, and partly from the thought that pro- 
vision for the present is necessary both for itself and for 
the future as well. 

§ 4. Influence of Uncertainties of Income 

The next influence on the rate of impatience and there- 
fore on the rate of interest consists in the risks or uncertain- 
ties attaching to prospective incomes. Now uncertainties 
affect impatience in several different ways. In general, 
risks tend to raise the degree of impatience. There are 
four ways in which risk tends to increase, and one in which 
it tends to decrease, impatience. 

First, we know that if a loan is risky, the rate of interest 
has to be high. If the repayment of a loan is regarded as 
uncertain, this uncertainty will have to be offset by an 
increase in the rate of interest, and produces a correspond- 
ingly high rate of impatience for risky loans. 

But even the rate of interest in riskless loans will be raised 
by risk in certain ways now to be discussed. The second 
way in which risk tends to raise the rate of impatience is in 
the risk of life. It acts like the risk of a loan. You may 
tell a man he is perfectly sure of being repaid his loan fifty 
years from now. Nevertheless, that will not cause him to 
regard the money which will come fifty years hence as 
equal in value to the money which he has in his pocket to- 
day, because he runs the risk of dying inside of fifty years ; 
it is cold comfort to tell him he is sure to get his money after 
he is dead ! A sailor is a type of man who is constantly 
taking this fact into account. He knows that almost any 
day he may be shipwrecked, and the consequence is that 
he prefers money in his pocket to-day to money next year. 



358 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 

Sailors are proverbial spendthrifts and have a proverbially 
high degree of impatience. 

The third way in which risk tends to increase impatience 
is seen where present income is risky as compared with 
future income. A man in time of war, when there is pros- 
pect of peace in the future, looking forward to a relatively 
safe income in the future, will have a high degree of im- 
patience for that future to arrive, because the present risky 
income is in his eyes not equivalent to the future safe income. 

Fourthly, the risk of income may, instead of applying 
especially to remote periods or especially to immediate 
periods, apply to all alike. Such a condition largely explains 
why salaries and wages are lower than the average earnings 
of those who work for themselves. Those who choose salaries 
rather than profits are willing to accept a small but sure 
income in order to get rid of a precarious though possibly 
larger one. Since a risky income, if the risk applies evenly 
to all parts of the income-stream, is nearly equivalent to a 
low income, and since a low income, as we have seen, tends 
to intensify impatience, risk, if uniformly distributed in 
time, must tend to increase impatience. 

These, then, are the four ways in which risk tends to 
increase impatience. There is, however, one way in which 
risk tends to decrease impatience. The instance just given 
is one in which income in the immediate future is risky, but 
income thereafter safe. That sometimes happens, as just 
indicated, where in time of war man expects peace in the 
future, or in time of sickness he expects to get well and re- 
sume his regular earning power. Nevertheless, there are 
numerous examples of the opposite type, where the risk 
applies to the future and not to the present. If a ship owner, 
for instance, has his ship in port to-day, but is going to sail 
within a few months, his risks are high in the future as com- 
pared with the present. His future looks dubious, and that 
will cause him to be less impatient, because a risky future 
income is equivalent to a small future income, and 



Sec. 4] INFLUENCES ON IMPATIENCE FOR INCOME 359 

we have seen that a small future income tends to 
lessen impatience. An income which gets more and more 
risky in the future is therefore like an income which gets 
smaller and smaller in the future. In actual fact, such a 
type is not uncommon. The remote future is usually less 
known than the immediate future. This means that the 
risk connected with distant income is greater than that con- 
nected with income near at hand. The chance of disease, 
accident, disability, or death is always to be reckoned with, 
but under ordinary circumstances is greater in the remote 
future than in the immediate future. Consequently there 
is usually a tendency, so far as this influence goes, toward 
a low rate of impatience. This tendency is expressed in 
the phrase to " lay up for a rainy day." 

Risk, then, operates in diverse ways according to diverse 
circumstances. We see that risk tends in some cases to in- 
crease and in others to decrease the rate of impatience. 
There is a common principle, however, in all these cases. 
Whether the result is a high or a low rate of impatience, the 
the primary fact is that the risk of losing the income in a 
particular period of time operates as a virtual impoverish- 
ment of the income in that period, and hence increases the 
estimation in which it is held. If that period is a remote 
one, the risk to which it is subject makes for a high appre- 
ciation of remote income and a low rate of impatience ; if 
the period is the immediate future, the risk makes for a 
high appreciation of immediate income and a high rate of 
impatience ; if the risk is in all periods of time, it acts as 
a virtual decrease of income all along the line and promotes 
a high rate of impatience. 

The rate of impatience depends, then, upon the time- 
shape of an income-stream, its size, and its uncertainties. 



CHAPTER XXII 

THE DETERMINATION OF THE RATE OF INTEREST 

§ i. Equalizing Marginal Rates of Impatience by 
Borrowing and Lending 

In the preceding chapter we saw that the rate of prefer- 
ence for present over future goods is, in the last analysis, 
a preference for present over future income ; that this pref- 
erence depends, for any given individual, upon the char- 
acter of his income-stream — its size, time-shape, and un- 
certainties — and that the nature of this dependence varies 
with different individuals. 

The question now arises : Will not the rates of impatience 
of different individuals be very different, and if so, what 
relation do these different rates have to the rate of interest ? 
It might seem at first that the rates of impatience would 
differ so widely that there could be no such thing as a rate 
of interest. But this is incorrect. In a nation of hermits, 
without any mutual lending and borrowing, this would be 
true; the rate of impatience of individuals would then 
diverge widely and there would be no common market rate 
of interest. It is modern society's habit of borrowing and 
lending that tends to bring into equality the rates of im- 
patience in different minds, and it is only because of the 
limitations of the loan market that absolute equality is not 
reached. 

The chief practical limitation to lending is due to the risk 
involved, and to the difficulty or impossibility of obtaining 
the security necessary to eliminate or reduce that risk. 

360 



Sec. i] DETERMINATION OF THE RATE OF INTEREST 36 1 

Those who are most willing to borrow are frequently those 
who are least able to give security. It will then happen 
that these persons, shut off from the loan market, experience 
a higher rate of impatience than the rate of interest ruling 
in that market. If they can contract loans at all, it will be 
only through the pawnshop or other high-rate agencies. 

But for the moment let us assume a perfect market, in 
which the element of risk is entirely lacking, both with 
respect to the certainty of the expected income-streams 
belonging to the different individuals, and with respect 
to the certainty of repayment for loans. In other words, we 
assume that all individuals are initially possessed of fore- 
known income-streams, and are free to exchange any parts 
of them so that present income is exchanged for future 
income. We assume, further, that to buy and sell various 
parts of one's income-stream (by loans, etc.) is the only 
method of altering that income-stream. Prior to such 
exchange, the income-stream is supposed to be rigid, i.e., 
fixed in size and time-shape. The capital instruments which 
the individual possesses are each supposed to be capable 
of only a single definite series of benefits contributing to his 
income-stream. 

Under these hypothetical conditions, the rates of impa- 
tience for different individuals would be perfectly equalized. 
Borrowing and lending evidently affect the time-shape of 
the incomes of borrower and lender; and since the time- 
shape of their incomes affects their rate of impatience, such 
a modification of time-shape will react upon and modify 
their rate of impatience and bring the market into equi- 
librium. 

For if, for any particular individual, the rate of im- 
patience differs from the market rate, he will, if he can, 
adjust the time-shape of his income-stream so as to har- 
monize his rate of impatience with the interest rate. For 
instance, those who, for a given income-stream, have a rate of 
impatience above the market rate, will sell some of their 



362 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

surplus future income to obtain (i.e., " borrow") an addition 
to their present meager income. This will have the effect 
of enhancing the value of the remaining future income 
and decreasing that of the present. The process will 
continue until the rate of impatience of this individual 
is equal to the rate of interest. In other words, a person 
whose impatience rate exceeds the current rate of interest 
will borrow up to the point which will make the two rates 
equal. Reversely, those who, with a given income-stream, 
have a rate of impatience below the market rate, will sell (i.e., 
" lend ") some of their abundant present income to eke out 
the future, the effect being to increase their rate of impa- 
tience until it also harmonizes with the rate of interest. 

To put the matter in figures, let us suppose the rate of 
interest is five per cent, whereas the rate of impatience of a 
particular individual is at first ten per cent. Then, by 
hypothesis, the individual is willing to sacrifice $1.10 of next 
year's income in exchange for $1 of this year's. But in the 
market he is able to obtain $1 for this year by spending only 
$1.05 of next year's income. This ratio is, to him, a cheap 
price. He therefore borrows, say, $100 for a year, agreeing 
to return $105 ; that is, he contracts a loan at five per cent 
when he is willing _ to pay ten per cent. This loan, by in- 
creasing his present income and decreasing his future, tends 
to reduce his rate of impatience from ten per cent to, say, 
eight per cent. Under these circumstances he will borrow 
another $100, being now willing to pay eight per cent, but 
having to pay only five per cent. This loan will still 
further reduce his rate of impatience. He will continue to 
borrow until his rate of impatience has been finally brought 
down to five per cent. Then for the last or " marginal " 
$100, his rate of impatience will agree with the market 
rate of interest. As in the general theory of prices, this 
marginal rate, five per cent, being once established, applies 
indifferently to all his valuations of present and future in- 
come. Every comparative estimate of present and future 



Sec. i] DETERMINATION OF THE RATE OF INTEREST 363 



which he actually makes must be " on the margin " of his 
income-stream as actually determined. 

In like manner, if another individual, entering the loan 
market from the other side, has at first a rate of impatience 
of two per cent, he will become a lender instead of a borrower. 
He will bewilling to accept $102 of next year's income for $100 
of this year's income, but in the market he is able, instead of 
the $102, to get $105. As he can lend at five per cent when 
he would gladly do so at two per cent, he jumps at the chance 
and invests, not one Si 00 only, but another and another. 
But his present income, being reduced by the process, is now 
more highly esteemed than before, and his future income, 
being increased, is less highly esteemed. The result will be 
a higher relative valuation of the present, which, under the 
influence of successive additions to the sums lent, will rise 
gradually to the level of the market rate of interest. 

In such an ideal loan market, therefore, where every in- 
dividual could freely borrow or lend, the rates of impatience 
for all the different individuals would become equal to each 
other and to the rate of interest. 

To illustrate these principles by diagrams, let us suppose 
a man has a given income-stream, as indicated in Figure 44. 
It is assumed 
that his income- 
stream is an as- 
cending one, as 
between this 
year and next 
year ; that is, 
that the income 
for the year 
1 910 is relatively 
small and that for 191 1 is relatively large. It may be that 
this year he is ill, and therefore has not earned his usual 
amount of money, and that next year he expects to get an 
unusual income from some particular source. This man will 



700 
60O 
500 

400 



'lOO Borrowed-* i 
300 



200 
IOO 



3 



105 Returned. 



1910 1911 

Fig. 44. 



1912 



1913 



364 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

then probably be impatient to get the large income he an- 
ticipates. He does not wish to wait till next year if he can 
avoid waiting. His impatience is due to a scarcity of income 
this year and an abundance of income next year. He will 
wish to adjust his income or rectify the disparity by increas- 
ing this year's income at the expense of next year's income. 
He will borrow, but borrowing changes the time-shape of his 
income-stream. His original income in the first year is 
$300, indicated by the dark line for the year 1910. Next 
year his income is $600, indicated by the dark line for that 
year. The effect of borrowing will be to elevate the first 
line by $100 and to depress the second by $105. These 
two adjustments will lessen both the scarcity of this year's 
income and the abundance of next year's income. This will 
therefore modify the time-shape of his income and lessen the 
valuation he puts on a dollar this year as compared with 
next year. This reduces the premium he puts on this year's 
dollar, i.e., his rate of impatience. By increasing his loan he 
can evidently reduce this premium to conform to the rate of 
interest. He can also make other loan contracts, or plan to 
make them later, by which he can increase or decrease any 
year's income at the expense of an opposite change in that 
of some other year or years. In this way he can alter the 
time-shape of his income-stream at will, and he will always 
so alter it as to make his rate of impatience equal to the rate 
of interest. He began with a rate of impatience greater 
than the market rate of interest, but ended in harmony with 
that rate. 

Figure 45 represents the income-stream of a "man sup- 
posed to have a rate of impatience at first less than the 
rate of interest. If we choose, we may suppose that he 
has just received a small legacy which makes this year's 
available income unusually large, say $600, while he expects 
next year to have an unusually small income. Looking 
forward to next year, he sees that it will be hard to get along 
comfortably, while this year he has more than he needs. 



Sec. i] DETERMINATION OF THE RATE OF INTEREST 365 



• 

700 
600 
500 
400 




























































snt - 






































<i 




























j— *I05 Returned 






IIOO 
O 

























































































I9IO 



1911 

Fig. 45. 



1912 1913 



He therefore invests some of his present abundance to the 
extent of $100 in order to eke out his future scarcity by $105. 
He will do so, however, only provided his rate of impatience 
is less than the market rate of interest, five per cent, and 
he will do so only 
up to the point 
which will reduce 
his rate of im- 
patience to the 
level of this rate 
of interest. 

The two men 
started out with 
rates of im- 
patience different from the market rate of interest. The 
market rate was five per cent, while the first man had a rate 
of impatience above this, and the second a rate of impatience 
below this. But when they finished their loan operations or 
readjustments in the time-shape of their income-streams, 
they brought their rates of impatience each into harmony 
with the rate of interest and therefore with each other. 
Therefore, as long as there is a market in which everybody 
can borrow or lend at will at five per cent, everybody will 
have at the margin a rate] of impatience of five per cent. 
Nobody will have a rate of impatience above five per cent, 
because, if it is at first above it, he will borrow enough 
to bring it down to the market rate ; and nobody will 
have a rate below it, because, if it is at first below 
it, he will lend enough to bring it up to the rate of 
interest. 

Even men of widely different natures as to foresight, 
self-control, etc., will have the same marginal rates of im- 
patience. If such different men start with precisely the 
same sorts of income, they will have different rates of im- 
patience. But in that case they will not continue to have 
the same sorts of income. They will severally modify 



366 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

their income-streams until, for the diverse natures of these 
men, equal rates of impatience are effected. 

§ 2. Equalizing Marginal Rates of Impatience by 
Spending and Investingj 

It must not be imagined that the classes of borrowers and 
lenders correspond respectively with the classes of poor and 
rich. Personal and natural idiosyncrasies, early training, 
and acquired habits, accustomed style of living, the usages 
of the country, and other circumstances will, by influencing 
foresight, self-control, regard for posterity, etc., determine 
whether a man's rate of impatience is high or low, and 
whether he becomes a borrower or a lender. 

It should be noted that borrowing and lending are not 
the only ways in which one's income-stream may be modi- 
fied. The same result may be accomplished simply by buy- 
ing and selling property; for, since property rights are 
merely rights to particular income-streams, their exchange 
substitutes one such stream for another of equal value but 
differing in time-shape, or certainty. This method of 
modifying one's income-stream, which we shall call the 
method of sale, really includes the former method of loan ; 
for a loan contract is at bottom a sale ; that is, it is the ex- 
change of the right to present or immediately ensuing in- 
come for the right to more remote or future income. A 
borrower is a seller of a note of which the lender is the buyer. 
A bondholder is regarded indifferently as a lender and as a 
buyer of property, called a bond. 

The concept of a loan may therefore now be dispensed 
with by being merged in that of sale. By selling some prop- 
erty rights and buying others it is possible to transform 
one's income-stream at will, whether in time-shape or cer- 
tainty. Thus, if a man buys an orchard, he is providing 
himself with future income in the use of apples. If, instead, 
he buys apples, he is providing himself with similar but 



Sec. 3] DETERMINATION OF THE RATE OF INTEREST 367 

more immediate income. If he buys securities, he is pro- 
viding himself with future money, convertible when received 
into true or enjoyable income. If his security is a share in 
a mine, his income-stream is less lasting, though it may be 
larger, than if the security is stock in a railway. 

Purchasing the right to remote enjoyable income is called 
investing; purchasing the right to immediate enjoyable 
income is called spending. The antithesis between " spend- 
ing " and " investing " rests upon the antithesis between 
immediate and remote income. The adjustment between 
the two determines the time-shape of one's income-stream. 
Spending increases immediate income, but robs the future, 
whereas investing provides for the future to the detriment 
of the present. 

From what has been said it is clear that by buying and 
selling property an individual may change the conformation 
of his income-stream precisely as though he were specifically 
lending or borrowing. Thus, if a man's original income- 
stream consists of $1000 this year and $1500 next year, 
and if, selling this income-stream, he buys with the proceeds 
another yielding $1100 this year and $1395 next year, he 
has not, nominally, borrowed $100 and repaid $105, but 
he has done what amounts to the same thing — increased 
his income-stream of this year by $100 and decreased that of 
next year by $105, the $100 being the modification produced 
in his income for the first year by selling his original income- 
stream and substituting the second one, and $105 being 
the reverse modification in next year's income. 

§ 3. Futility of Prohibiting Interest 

We may now note that interest taking cannot be pre- 
vented by prohibiting loan contracts. To forbid the par- 
ticular form of sale, called a loan contract, would leave 
possible other forms of sale, and, as has been shown, the 
valuation of every property right involves interest. If the 



368 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

prohibition should leave individuals free to deal in bonds, 
it is clear that virtually they would be still borrowing and 
lending, but under the name of " sale " ; and if " bonds " 
were tabooed, they could merely change the name to " pre- 
ferred stock." It can scarcely be supposed that any pro- 
hibition of interest-taking would extend to the prohibition 
of all buying and selling; but as long as buying and 
selling of any kind were permitted, the virtual effect of 
lending and borrowing would be retained. The possessor 
of a forest of young trees, not being able to mortgage their 
future return, and being in need of an income-stream of a less 
deferred type than that receivable from the forest itself, 
would simply sell his forest, and with the proceeds buy, 
say, a farm with- a uniform flow of income, or a mine with 
a decreasing one. On the other hand, the possessor of a 
capital which is depreciating, that is, which represents an 
income-stream great now but steadily declining, and who 
is anxious to " save " instead of " spend," would sell his 
depreciating wealth and invest the proceeds in some such 
instrument as the forest already mentioned. 

It was in such ways, as, for instance, by " rent-purchase," 
that the medieval prohibitions of usury were rendered 
nugatory. Practically, at the worst, the effect of restrictive 
laws is simply to hamper and make difficult the finer 
adjustments of the income-stream, compelling would-be 
borrowers to sell wealth yielding distant returns instead 
of mortgaging it, and would-be lenders to buy the same, in- 
stead of lending to the present owners. It is conceivable 
that " explicit " interest might disappear under such restric- 
tions, but " implicit " interest would remain. The young 
forest sold for $10,000 would bear this price, as now, because 
it would be the discounted value of the estimated future in- 
come ; and the price of the farm bought for $10,000 would be 
determined in like manner. The rate of discount in the two 
cases must tend to be the same, because, by buying and 
selling, the various parties in the community would adjust 



SEC. 4] DETERMINATION OF THE RATE OF INTEREST 369 

their rates of impatience to a common level — an implicit 
rate of interest thus lurking in every contract, though never 
specifically appearing therein. Interest is too omnipresent 
a phenomenon to be eradicated by attacking any particular 
form; nor would any one undertake it who perceived the 
substance as well as the form. In substance, the rate of 
interest represents the terms on which the earlier and later 
elements of income-streams are exchangeable against each 
other. Interest can never disappear until present and future 
dollars will exchange at par. This would imply that human 
beings were no longer impatient, but considered it no hard- 
ship to wait indefinitely. 

We have supposed each person's income to be " rigid," 
except as it is modified by borrowing and lending, or buying 
and selling. It will, however, make little difference if each 
income, instead of being rigid, is more or less flexible to start 
with. Often the same article may be used in more than 
one way. In such a case the owner merely chooses the way 
which gives the capital the highest value. Since any time- 
shape may be transformed into any other, he need not be 
deterred from selecting an income because of its time-shape, 
but may choose it exclusively on the basis of maximum 
present value. 

§ 4. Clearing the Loan Market 

We have seen that from the standpoint of the individual, 
when a rate of interest is given, he will adjust his rate of 
impatience to correspond with that rate of interest. 

For him the rate of interest is a relatively fixed fact, 
since his own rate of impatience and resulting action can 
affect it only infinitesimally. All he can do is to adjust his 
rate of impatience to it. For society as a whole, however, 
these rates of impatience determine the rate of interest. 
This corresponds to what was said as to the determination 
of prices. We have seen that each individual regards the 

2B 



370 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

market price, say, of coal, as fixed, and adjusts his marginal 
desirability or undesirability to it; whereas, for the entire 
group forming the market, we know that these marginal 
desirabilities and undesirabilities fix the price of coal. In 
the same way, while for the individual the rate of interest 
determines the rate of impatience, for society the rates of 
impatience of the individuals determine the rate of interest. 
The rate of interest is simply the rate of impatience upon 
which the whole community may concur in order that 
the market of loans may be exactly cleared. Supply and 
demand will work this out. 

To put the matter in figures : if the rate of interest is set 
very high, say twenty per cent, there will be relatively few 
borrowers and many would-be lenders, so that the total 
extent to which would-be lenders are willing to reduce their 
income-streams for the present year for the sake of a much 
larger future income will be, say, $100,000,000; whereas, 
those who are willing to add to their present income at the 
high price of twenty per cent interest will borrow only, say, 
$1,000,000. Under such conditions the demand for loans 
is far short of the supply, and the rate of interest will there- 
fore go down. At an interest rate of ten per cent, the present 
year's income offered as loans might be $50,000,000, and the 
amount which would be taken at that rate only $20,000,000. 
There is still an excess of supply over demand, and interest 
must needs fall further. At five per cent we may suppose 
the market cleared, borrowers and lenders being willing 
to take or give, respectively, $30,000,000. In like manner it 
can be shown that the rate would not fall below this, as in 
that case it would result in an excess of demand over supply, 
and cause the rate to rise again. 

We have sketched the main principles determining the rate 
of interest. Some have not been mentioned save by im- 
plication. In summary we may say that the rate of inter- 
est, considered independently of fluctuations in the monetary 
standard, is determined by six conditions. Those which we 



Sec. 4] DETERMINATION OF THE RATE OF INTEREST 37 1 

have above considered and explained are the following three : 
(1) the dependence of impatience upon prospective income — 
its size, shape, and uncertainties ; (2) the tendency of the 
rates of impatience for different individuals to become equal 
to each other and to what becomes the rate of interest, 
through the loan market ; (3) the fact that supply and de- 
mand must be equal so that the modifications in the income- 
streams of individuals, through buying and selling, or borrow- 
ing and lending, must " clear the market." Of the other 
three determining conditions the most important is that 
the rate of interest must be equal not only to the marginal 
rates of impatience, but also to the "marginal rates of return 
on sacrifice." This principle — that rates of return on 
sacrifice harmonize with the rate of interest — may also be 
stated in the following form : of all the optional uses to which 
a man may put his capital he will choose that one which at 
the market rate of interest maximizes the present value of 
his capital. What, then, determines the value of the capi- 
tal? It is obviously not the sum of the discounted values 
of the different income-streams, but the discounted value 
of that one which is chosen in preference to all the others. 

The remaining two conditions are the very obvious ones ; 
one condition being that what is borrowed at any time by 
some persons equals what is loaned at that time by other 
persons, and the other condition being that what any person 
borrows at one time must be repaid by that person at another 
time with interest at the market rate. 

Thus the rate of interest is the common market rate of 
impatience for income, as determined by the supply and 
demand of present and future income. Those who have 
a high rate of impatience strive to acquire more present 
income at the cost of future income, and tend to raise the 
rate of interest. These are the borrowers, the spenders, the 
sellers of property yielding remote income, such as bonds 
and stocks. On the other hand, those who — having a low 
rate of impatience — strive to acquire more future income 



372 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

at the cost of present income, tend to lower the rate of 
interest. These are the lenders, the savers, the investors. 

The mechanism just described will not only result in a 
rate which will clear the market for loans connecting the 
present with next year, but, applied to exchanges between 
the present and the remoter future, it will make similar 
adjustments. While some individuals may wish to ex- 
change this year's income for next year's, others wish to 
exchange this year's income for that of the year after next, 
or for income several years in the future. The rates of 
interest for these various periods are so adjusted as to clear 
the market for all the periods of time for which contracts 
are made. That is, supply and demand must be equal, so 
as to clear the market for every period of time. 

§ 5. Historical Illustrations 

We have now completed our study of the causes deter- 
mining the rate of interest. If they are correct, we should find 
that the rate of interest is low (1) if in general the people are 
by nature thrifty, farsighted, self-controlled, or thought- 
ful for the future welfare of their children, or (2) if they have 
large or descending income-streams ; and that it is high (1) 
if the people are shiftless, shortsighted, impulsive, selfish, 
or (2) if they have small or ascending income-streams. 

History shows that facts accord with these conclusions. 
The communities and nationalities which are most noted 
for the qualities mentioned — foresight, self-control, and 
regard for posterity — are probably Holland, Scotland, 
England, and France. Among these people interest has been 
low. Moreover, they have been money lenders ; they have 
the habit of thrift or accumulation, and their instruments 
of wealth are in general of a durable kind. 

On the other hand, among communities and peoples noted 
for lack of foresight and for negligence with respect to the 
future are China, India, Java, the negro communities in 



Sec. 5] DETERMINATION OF THE RATE OF INTEREST 373 

the Southern states, the peasant communities of Russia, 
and the North and South American Indians, both before 
and after they had been pushed to the wall by the white 
men. In all of these communities we find that interest is 
high, that there is a tendency to run into debt and to dis- 
sipate rather than accumulate capital, and that their dwell- 
ings and other instruments are of a very flimsy and perishable 
character, built for immediate, not remote, gratifications. 
This is true even where, as in China, the people are 
industrious. Industry without patience will result in hard 
work, but this work will be for immediate and not remote 
gratifications. 

These examples illustrate the effect on the rate of in- 
terest of differences in human nature. We now turn to 
illustrations of differences in the time-shape of incomes. 
The most striking examples of increasing income-streams 
are found in new countries. It may be said that the United 
States has almost always belonged to this category. 

In America we see exemplified on a very large scale the 
truth of the theory that a rising income-stream raises, and 
a falling income-stream depresses, the rate of interest, or 
that these conformations of the income-stream work out 
their effects in other equivalent forms. A similar causation 
may be seen in particular localities in the United States, 
especially where changes have been rapid, as in mining 
communities. In California, in the two decades between 
1850 and 1870, following the discovery of gold, the income- 
stream of that state was increasing at a prodigious rate. 
During this period the rates of interest were abnormally 
high. The current rates in the " early days " were quoted 
at one and one half to two per cent a month. " The thrifty 
Michael Reese is said to have half repented of a generous 
gift to the University of California, with the exclamation, 
'Ah, but I lose the interest,' a very natural regret when in- 
terest was twenty-four per cent per annum." After railway 
connection, in 1869, Eastern loans began to flow in. The 



374 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

decade 1 870-1 880 was one of transition during which the 
phenomenon of high interest was gradually replaced by the 
phenomenon of borrowing from outside. The residents of 
California were thus able to change the time-shape of their 
income-streams. The rate of interest consequently dropped 
from eleven per cent to six per cent. 

The same phenomena of enormous interest rates were 
also exemplified in Colorado and the Klondike. There were 
many instances in both these places during the transition 
period from poverty to affluence, when loans were contracted 
at over fifty per cent per annum, and the borrowers regarded 
themselves as lucky to get rates so " low." 

§ 6. Interest and Prices 

We have seen that the rate of interest is not a mere tech- 
nical phenomenon, restricted to Wall Street and other 
" money markets," but that it permeates all economic re- 
lations. It is the link which binds man to the future and 
by which he makes all his far-reaching decisions. It enters 
into the price of securities, land, and capital-goods gener- 
ally, as well as into rent, wages, and the value of all " inter- 
actions." 

The rate of interest plays a central role in the theory of 
prices. It operates in the determination of the price of 
wealth, property, and benefits. As was shown in previous 
chapters, the price of any article of wealth or property is 
equal to the discounted value of its expected future benefits. 
If the value of these benefits remains the same, a rise or 
fall in the rate of interest will cause a fall or rise respectively 
in the value of all instruments of wealth. The extent of this 
fall or rise will be the greater, the farther into the future 
the benefits of wealth extend. 

As to the influence of the rate of interest on the price of 
benefits, we first observe that benefits may be interactions 
or satisfactions. The value of interactions is derived from 



Sec. 6] DETERMINATION OF THE RATE OF INTEREST 375 

the succeeding future benefits to which they lead. For 
instance, the value to a farmer of the benefits of his land in 
affording pasture for sheep will depend upon the discounted 
value of the benefits from the flock in producing wool. The 
value of the wool output to the woolen manufacturer is in 
turn influenced by the discounted value of the output of 
woolen cloth to which it contributes. In the next stage, the 
value of the production of woolen cloth will depend upon the 
discounted value of the income from the production of woolen 
clothing. Finally, the value of the last named will depend 
upon the expected income which the clothing will bring to 
its wearers — in other words, upon the use of the clothes. 

Thus the final benefits, consisting of the use of the clothes, 
will have an influence on the value of all the anterior benefits 
of tailoring, manufacturing cloth, producing wool, and 
pasturing sheep, while each of these anterior benefits, when 
discounted, will give the value of the respective capital 
which yields it ; namely, the clothes, cloth, wool, sheep, 
and pasture. We find, therefore, that not only all articles 
of wealth, but also all the " interactions " which they render, 
are for their value dependent upon final enjoyable uses, 
and are linked to these final uses by the rate of interest. 
If the rate of interest rises or falls, this chain will shrink or 
expand. The chain hangs, so to speak, by its final link of 
enjoyable benefits, and its shrinkage or expansion will there- 
fore be most felt by the links most distant from these final 
benefits.. At the close of Chapter VI it was shown that a 
change in the rate of interest only slightly affects the value of 
a suit of clothes, the benefits from which are soon realized, 
but greatly affects the value of land, the benefits of which 
stretch out into the distant future. So a change in the rate 
of interest will affect but slightly the price of making clothing 
from which the final benefits will occur in a short time, but 
will affect materially the price of pasture for sheep to secure 
the final benefits from which will require a longer time. 

A study, therefore, of the theory of prices involves (i) a 



376 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

study of the laws which determine the final benefits on 
which the prices of anterior interactions depend; (2) a 
study of the prices of these anterior interactions, as de- 
pendent, through the rate of interest, on the final benefits ; 
(3) a study of the price of capital-instruments and capital- 
property as dependent, through the rate of interest, upon 
the prices of their benefits. The first study, which seeks 
merely to determine the laws regulating the price of final 
benefits, is relatively independent of the rate of interest. 
The second and third, which seek to show the dependence on 
final benefits of the anterior benefits and of the capitals which 
bear them, involve and depend upon the rate of interest. 

In the theory of prices we found that the ultimate ele- 
ments supplied and demanded were satisfactions and efforts. 
But there is involved in each price another special price, viz., 
the rate of interest. Without the rate of interest we may 
only compare simultaneous satisfactions or efforts. With it 
we may compare all that exist. By means of the rate of 
interest any future satisfaction or effort is discounted, and 
thus translated into terms of present value. It enables us 
to pause at every step and appraise the interactions and cap- 
ital which anticipate future satisfactions. In other words, 
by it we capitalize income and form our capital accounts. 

Interest, then, is the universal time-price, Unking im- 
pending and remote satisfactions, or efforts, or both. It is 
literally the previously missing link necessary for a complete 
comparison of efforts and satisfactions at all points of time. 

The study of the rate of interest, therefore, rounds out 
and completes our study of prices. 

§ 7. Classification of Price Influences 

We may now fitly review the theory of prices by enumer- 
ating the various possible causes which might decrease the 
price of, let us say, pig iron in New York. Its price may 
fall for any one or more of the following reasons : — 



Sec. 7] DETERMINATION OF THE RATE OF INTEREST 377 

I. A rise in the marginal desirability of money due either to 

A . A rise in the purchasing power of money through 

1 . A decrease in money or deposit currency, or 

2. A decrease in their velocities, or 

3. An increase in the volume of trade; or to 

B. An impoverishment or reduction of incomes. 

II. A fall in the marginal desirability of pig iron due either to 

A. An increase in the amount of pig iron used, through 

1. Importation of pig iron from other places where its 

price is lower than in New York, or 

2. Short sales of pig iron for future delivery in ex- 

pectation of a fall of price, thus releasing to pres- 
ent use such stocks as would otherwise be held 
over for the future, or 

3. A decrease in its cost by 

o. A saving of waste, 

b. A saving of labor, 

c. A decrease in the price of iron ore or other 

prices entering into its cost, 

d . An increase in the price of by-products, or 
4. A trade war ; or to 

B. A fall in the marginal desirability of a given quantity of pig 

iron, through 

1. A decrease in the price of iron products through a 

decrease in the marginal desirability of the satis- 
factions they yield, because of 

a. An increase in their amount, 

b. A change in fashion, etc., or 

2. An increase in substitutes for pig iron, or 

3. A decrease in complementary articles., or 

4. An increase in the rate of interest whereby the value 

of pig iron is to be discounted, through an in- 
crease in the marginal rates of impatience, 
o. From a change in human nature 

(1) By decreasing foresight, 

(2) By decreasing self-control, 

(3) By increasing shiftless habits, 

(4) By decreasing regard for posterity, or 
b. From a change in incomes 

(1) By steepening their time-shape, 

(2) By reducing their size, 

(3) By increasing their uncertainties. 



378 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

Back of these causes lie other causes, multiplying end- 
lessly as we proceed backward. But if we trace back all 
of these causes to their utmost limits, they will all resolve 
themselves into changes in the marginal desirability or 
undesirability of satisfactions and of efforts, respectively, 
at different points of time, and in the marginal rate of 
impatience as between any one year and the next. 



CHAPTER XXIII 



INCOME FROM CAPITAL 



§ i. Distribution according to Agents of Production and 
according to Owners 

We began this book with a study of economic accounting. 
In this way we obtained a bird's-eye view of the whole field 
of economic science. At that time we had to take ready- 
made the material for constructing our accounts. This 
material consisted of the values of various items, whether 
of capital or of income. These values consist in each case 
of two factors, the quantity of the good valued and the 
price of that good. We have now finished the study of 
one of these two factors, price, and there remains for us 
only the study of the other, quantity. We have explained 
how the price of instruments, property rights, and benefits, 
which enter into capital and income accounts, is determined. 
We have still to explain how the quantities of instruments, 
property rights, and benefits are determined. What deter- 
mines, for instance, the quantity of wheat which a given 
wheat field will produce ; what determines the quantity of 
the wheat fields ; what determines the quantities of the 
necessities, comforts, luxuries, and amusements of life which 
a nation or an individual possesses ; what determines the 
quantities of human beings on a given area ? Once we can 
explain these quantities, we need only multiply by the 
prices previously explained, and we have completed our 
task of explaining economic quantities, prices, and values. 
We shall then be able to explain — at least in general terms 
— why, for instance, the quantities and values of the capital 
or income in capital-accounts, or income-accounts of some 

379 



380 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

communities or individuals are so great, and those of others 
so little ; why the benefits flowing from one piece of land 
are so great, and from another so small ; and so forth. 

Our purpose is not so much to reach absolute, as rela- 
tive, results. We care less about the absolute population 
of the globe than about population relatively to land. We 
care less about the world's total yield of wood than about 
the yield per capita of human beings, or per acre of wood- 
land ; less about the total yield of cloth than about the 
yield per capita or per loom. In general, we care less 
about the total amount of the yield from the aggregate of 
any kind of capital than about the yield per capita and per 
unit of that capital. 

Our present search, then, is for relative quantities, or 
for relative values. There are two sets of such quantities, 
or of such values, which are of special importance in our 
study. One is the quantity and value of income per unit 
of physical capital which yields the income, and the other 
is the quantity and value of income and of capital per 
human being who owns the capital and the income from it. 
The first represents the distribution of income relatively to 
the agents which produce it. The second represents the 
distribution of income and of capital among their owners. 
The study of the first will occupy our attention in this and 
the following chapter. 

Our immediate task, therefore, is to study the ratios of 
income to capital. As we learned at the beginning, both 
capital and income may be measured either in quantity or 
in value. The ratio of income to the capital which pro- 
duces it takes different forms, according as the income and 
the capital are measured in one or the other of these two 
ways. 

As we saw at the beginning of Chapter XX, the original 
concept from which the others spring is that of physical 
capital. From this physical capital come its services or the 
quantity of income ; on the basis of this quantity of income 



Sec. i J INCOME FROM CAPITAL 38 1 

we derive in turn its value ; and from this value of income 
we pass back to the value of the original capital. The 
order is (1) instruments, (2) their benefits, (3) the value of 
these benefits, (4) the value of the instruments. We saw 
that the rate of interest was the ratio of (3) to (4), i.e., 
the ratio of income-value to capital-value. We are now to 
take up the ratio of item (3) to item (1), i.e., the value of 
the income from any quantity of capital per physical unit 
of that capital. 

The latter ratio is rent. This concept of rent is some- 
what broader than the popular concept, for it includes, 
besides the rent explicitly named in a lease between land- 
lord and tenant, the rent which is implicit when there are 
not two persons involved, but landlord and tenant are one 
and the same person. Explicit rent is rent in the usual 
and strict sense of the term. Implicit rent is often called 
capitalists' profits. That is, explicit rent occurs when the 
income is stipulated; it consists of a definite payment for 
the use of the instrument. This occurs when the owner 
of the instrument " rents " it to another person and gets 
from it a definite money-income by selling its use. Implicit 
rent occurs when the income is not stipulated, and therefore 
can only be appraised. When a landlord rents his land to 
a tenant for $1000 a year, the rent is explicitly $1000 a 
year ; when, instead, he works the land himself and makes 
from it an income which consists in the production of 
crops, the rent is only implicit. Before he can state its 
amount he must appraise the crops, including both those 
portions which he sells and those consumed by himself and 
his family. If he appraises the crops and other benefits he 
receives from the land at $3000 and the costs at $2000, his 
net income is $1000, and therefore his implicit rent is $1000. 
A " rented " house bears explicit rent, but a house lived 
in by the owner has an implicit rent, i.e., whatever benefits 
it yields to the owner reckoned over and above its costs. 

The most common kind of instruments explicitly rented is 



382 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

real estate, although many other more or less durable com- 
modities, such as furniture, horses and carriages, telephones, 
pianos, typewriters, and even clothing, may sometimes be 
explicitly rented. 

Explicit rent, being stipulated, is usually fixe d and certain 
— at least for all practical purposes ; implicit rent, on the 
other hand, is variable and uncertain. 

§ 2. The Rent of Land 

Although a piece of real estate is usually rented as a 
whole, including both land and improvements thereon, 
sometimes the land and the improvements are rented 
separately. The- rent of land separately is called ground 
rent. Even when ground rent is not separated in contract, 
it may, for purposes of discussion, be separated in thought ; 
so that all land bears ground rent, either explicit or implicit. 
Ground rent has been the subject of a vast amount of dis- 
cussion. It underlies, for instance, " the single tax " propa- 
ganda, which advocates that taxes shall be laid on ground 
rent alone. 

There are two important peculiarities of land which are 
shared by very few other instruments. One of these peculiar- 
ities is that, practically speaking, the land in the world is 
fixed in quantity. Except by filling in tidal lands, and in 
a few other instances, we cannot add to the world's acre- 
age ; nor can we subtract from it. It is true that in some 
cases we may materially increase its productivity by irriga- 
tion, fertilizing, etc., on the one hand, or decrease it by 
exhaustion of the soil and other abuses on the other. These 
alterations in land are more important than has sometimes 
been recognized, and their importance is increasing. For 
the present, however, we shall assume a community in 
which the land is fixed, both in quality and quantity, 
possessing, as Ricardo expresses it, " natural and inde- 
structible powers of the soil." For our purpose it is enough 



Sec. 2) INCOME FROM CAPITAL 383 

to assume that the land is indestructible. Whether it be 
natural or not is a matter of indifference ; precisely the same 
principles of valuation apply to the land which was wrested 
by our ancestors from the wilderness as apply to land which 
was solely a gift of nature. 

The second peculiarity of land is that different lands 
differ widely in quality. Land is not a uniform or homo- 
geneous article, like pig iron or granulated sugar, but 
consists of innumerable different grades suitable for almost 
innumerable different purposes. The prices of land have, 
therefore, a very wide range, and for the most part follow 
the principles of substitutes or competing articles. 

It is true that the various lands are not all substitutes. 
A city building site is not a substitute for wheat land, nor 
is it a substitute either for forest or mineral lands. But 
here, again, for the sake of simplicity, we first consider 
only wheat lands and shall assume that all these wheat 
lands are incapable of any other product and differ only 
in productivity as to wheat. We therefore assume : — 

(1) That these wheat lands are fixed in quantity. 

(2) That they differ in quality (i.e., productivity) by 
continuous gradation from very fertile to very infertile 
lands, each fixed and invariable as to wheat productivity 
and having no other product. 

(3) That the cost of tilling each acre is likewise fixed and 
invariable, say $10. 

(4) That the lands are substantially equal in accessibility 
(thus being in a common land-market and contributing 
wheat to a common wheat-market). 

Let us suppose, as represented in Figure 46, an island 
fulfilling the three conditions above mentioned. In order 
further to simplify the picture, let us suppose the most 
fertile land situated in the center capable of producing 25 
bushels of wheat per acre per year, and the other lands 
arranged around it spiral fashion in the order of descend- 
ing productivity. If there is a superabundance of the 



384 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

25-bushel-per-acre land so that it can be had merely for the 
trouble of occupying it, and there is no prospect that any 
inferior grades will ever need to be used, the land will be, 
like air, without value, and will yield no rent. The reason 




Fig. 46. 

is that the supply of land of the first quality, which 
may be had free, exceeds the amount demanded. We 
have seen that under such extreme conditions of supply 
and demand the price is low. No one will pay for the 
use of land when, without traveling farther than across 
a field, there is plenty of equally good land to be had 
for nothing. The wheat, however, will have a price equal, 
as previously explained, to its marginal desirability meas- 
ured in money and also to its marginal cost measured in 



Sec. 2] INCOME FROM CAPITAL 385 

money. But we have already assumed that this cost is 
fixed for each grade of land and is the same for every bushel. 
Consequently the price of wheat is in this case simply equal 
to the marginal cost of producing the wheat. For, if sellers 
should try to sell above this cost, buyers would prefer to 
grow the wheat at that cost themselves. Hence the value 
of a bushel produced on an acre of the first-grade land is 
only just equal to the cost of producing wheat there, which, 
at Sio per acre for 25 bushels, is $10 -f- 25, or 40 cents per 
bushel. 

But if the population so changes as to create a demand 
for wheat which cannot be supplied from the most fertile 
land, some of the next grade of land will be used, yielding 
24 bushels per acre. What was before true of only the 
first-grade land will then be true of this second-grade land. 
It will be valueless, and will yield no rent. But no longer 
will this be true of the first-grade land. It will have a 
value and yield a rent. For there will be a rise in the 
price of wheat. The price will still be equal to the mar- 
ginal cost, but now the marginal cost is the cost of producing 
a bushel on the second-grade land. The value of the 24 
bushels produced on this land will now be equal to the 
cost of producing 24 bushels on that land, i.e., $10. This 
is $10 -s- 24, or 41.6 cents a bushel. 

But since there cannot be two prices for the same article 
in the same market, the price of the wheat produced on 
the first-grade land must be the same as that produced on 
the second grade. Consequently, the owners of the first- 
grade land now have a crop worth more than the cost of 
producing it, and can now, if they choose, obtain a rent for 
it equal to the excess, i.e., one bushel per acre ; for a tenant 
paying the equivalent of one bushel per acre would have 
24 bushels for himself, which is exactly the same as he 
would get if he took up a claim for himself on the second- 
grade land; and if the landlord should attempt to charge 
more, he would lose his tenant, as the latter would then 

2C 



386 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

be better off on the second-grade land. If he charged less, 
he would be besieged by applications, and would put up 
his price. The market would be cleared by a rent of one 
bushel per acre. In money this is 41.6 cents per acre. If 
the owner does not rent his land to another, but enjoys the 
product himself, he is still said to obtain 41.6 cents an acre 
of implicit rent. 

If the population changes again so as to require a resort 
to the third-grade land, the price will be still higher, viz., 
$10 -s- 23, or 43^ cents per bushel ; and the rent of the first- 
grade land will rise to equal the difference between its pro- 
ductivity and that of the third-grade land, viz., 2 bushels 
per acre or 2 X 43^ cents, i.e., 87 cents per acre. Likewise 
the second-grade land will now bear a rent equal to its 
superiority over the third grade, viz., one bushel per acre, 
or 43I cents. In the same way we may reckon the rent 
under other states of land occupation. In each case the 
rent of any grade of land is the difference between its pro- 
ductivity and the productivity of the worst or marginal land 
occupied. If, for instance, the lowest grade of land occu- 
pied is that indicated in the table as having a productivity 
of 9 bushels per acre, the rent of the first grade is now 25 — 
9, or 16 bushels per acre ; that of the second grade, 24 — 9, 
or 15 bushels per acre ; that of the next, 23 — 9, or 14 bushels 
per acre ; and so on down to the worst land, which bears no 
rent. Since the price of wheat is, in all cases, its cost of pro- 
duction on the worst, or no-rent land, it will now be $10 for 
9 bushels, or $1.11 per bushel. Therefore in money the rents 
of the various lands from the best to the worst will be : — 

16 X $i.n or $17.76 per acre, 
15 X $1.11 or $16.65 P er acre > 
14 X $1.11 or $15.54 per acre, 
etc. 

The last, worst, or no-rent land, is sometimes also called 
the " Ricardian acre " in honor of Ricardo, who first stated 
this doctrine of land rent. Its scientific designation is 



Sec. 2] INCOME FROM CAPITAL 387 

"marginal acre " ; that is, it is the last acre whose cultivation 
can be made to pay. This marginal land in a sense fixes the 
rent of all other land and fixes the price of wheat. 

We have reached, then, two important results true under 
the conditions supposed, — 

(1) The price of wheat is equal to its cost of production on 
the margin of cultivation. 

(2) Ground rent of any land is the difference between the 
productivity of that land and the productivity of land on 
the margin of cultivation (i.e., the poorest land cultivated). 

With an increase of population, then, the price of wheat 
and the rent of wheat land will rise, and the owner of good 
land will become gradually wealthier merely through the 
increase in population. He receives an increase in rent, 
and the value of land — i.e., the capitalized or discounted 
rent — will therefore increase also. This increase in the 
value of the land is sometimes called the " unearned incre- 
ment " because it is due to no labor on the part of the 
landowner. It should be noted, however, that during the 
transition of rents from low to high, those who foresee a 
rise in rent will discount in advance the larger future rents. 
Not all so-called " unearned increments " are unexpected. 

These conclusions hold absolutely under the conditions 
assumed. But in the actual world these exact conditions 
are never exactly realized. Instead, we find, — 

(1) Land is not absolutely fixed in quantity. 

(2) The productivity of any piece of land is not fixed, but 
varies from time to time both in kind and in degree, and this 
productivity will vary with the price of its product, e.g., 
wheat. 

(3) The cost of tilling land is not fixed, but varies with 
different land, and, indeed, as we shall presently show, is 
influenced by the price of the product. 

(4) Some lands are much more distant to reach and 
occupy than others and their product much more difficult 
to bring to market. 



388 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

The first of these statements is of little practical im- 
portance. The others, however, require consideration. The 
productivity of land is not solely a matter of natural fertility. 
This might be the case with some mineral springs or oil 
wells ; but in most cases each piece of land may be more or 
less intensively cultivated, and a rise in the price of wheat 
will stimulate wheat production on all lands, the better 
grades included. Thus, if the first grade produced 25 bushels 
when no other land was in use, it would, with more outlay, 
produce more than 25 bushels as soon as the next grade 
was in use; and the poorer the worst grade was, and 
the higher the price of wheat, the greater would be the 
amount grown by those cultivating the superior grades of 
land. In other words, a change in the price of wheat would 
not only affect the amount of land under cultivation, but 
would affect also the intensity of cultivation of each piece 
of land. The productivity of each acre is not a constant 
quantity, but is indirectly dependent on the price. Each 
acre will be cultivated up to that degree of intensity at 
which the last dollar's worth of cost will barely repay itself. 
That is, not only is there a margin of cultivation as to 
acres — in other words, a last acre which it pays to culti- 
vate — but there is. also a margin of cultivation for every 
acre, good or bad, i.e., the last degree of effort or cost 
which it pays to put forth on any acre. Each acre will 
be tilled until this marginal cost of tilling agrees with the 
market price as determined by the cost of production on 
the most inferior land. 

Moreover, the land may be capable of other uses than 
wheat-growing, and a change in the price of wheat may 
shift the use to which certain lands are put. No theory of 
land rent is complete which assumes that the difference in 
quality among lands is merely a matter of different amounts 
of one product, like wheat. 

Again, as to the cost of tilling land per acre, this is by 
no means a constant quantity for all lands, both good and 



Sec. 2] INCOME FROM CAPITAL 389 

poor ; nor is it constant even for the same land. The cost 
of tilling may be either higher or lower on good land than 
on poor land ; and, as implied above, the cost on any 
land will vary with the price of the product, just as the 
product itself varies with the price. The higher the price, 
the greater will be the marginal cost. This is the law of 
increasing cost applied to agriculture. It is also often 
called " the law of diminishing returns " ; for to say that, 
as cultivation is either extended or intensified, the cost of 
producing a given amount of wheat continually increases 
is, turned about, evidently the same thing as to say 
that the amount produced at a given cost continually 
diminishes. 

Finally, lands differ so widely as to accessibility that 
tenants are reluctant to leave English lands, for instance, 
to take up lands in the Mississippi valley. A slight ad- 
vantage in the latter over the former will not suffice to 
produce emigration from the English to the American 
lands and to reduce the rents of the former. Only when 
the advantage is considerable will emigration ensue. The 
readjustments of population are therefore not as delicate 
as the readjustments of water between two connecting 
reservoirs seeking a common level. They resemble, rather, 
the readjustments of a viscous fluid like pitch which re- 
quires a considerable difference of level before the fluid 
will flow at all. The same viscosity applies in a less 
degree to the products of lands. These do not compete 
on even terms, for some lands are distant and others near 
the common market, and some have good and others poor 
transportation facilities. These differences are especially 
important in the case of bulky products such as hay which, 
for the reasons just given, differs very widely in price in 
different localities. 

While, therefore, the theory of rent as above given is 
correct under the ideal conditions assumed, it is not abso- 
lutely correct under the actual conditions we find in the 



390 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

world. In an absolutely correct theory the numbers ex- 
pressing productivity in Figure 46 must be conceived as 
increasing slightly as the margin of cultivation is extended, 
and the numbers expressing cost will not be simply a con- 
stant $10 per each acre, but will also increase slightly as 
the margin is extended. But these and the other modifica- 
tions necessary to make the theory of ground rent true to 
life are so slight as not materially to change the practical 
results. It still remains substantially true that the rent of 
any wheat land is equal to the difference between its pro- 
ductivity and the productivity of the worst wheat land 
under cultivation in the neighborhood. 

§ 3. Rent and Interest 

The principles of ground rent apply also to house rent, 
piano rent, or rent of any other kind, except that much 
greater divergencies from such illustrative figures as we 
gave for ground rent will be necessary in these cases. In 
particular, houses, pianos, etc., are not essentially fixed in 
quantity, but their quantity will be changed according to 
their rent and their price (which is the discounted value of 
their rent) . 

The practical difference between ground rent and other 
rent, such as house rent, has an important application in 
taxation. It is not within the scope of this book to con- 
sider problems of taxation. In treatises on taxation it is 
shown that a tax on ground rent falls on the landlord and 
does not appreciably affect the tenant, because it cannot 
affect the supply of land, which is practically fixed by nature ; 
whereas a tax on house rent is borne partly by the tenant, 
because it discourages house building and affects the supply 
of houses. The difference, then, between the rent of land 
and the rent of other instruments is a difference in the 
character of the supply. The supply of land is relatively 
fixed ; other instruments are reproducible. 



Sec. 3] INCOME FROM CAPITAL 39 1 

It is important to understand this difference and also not 
to confuse it with a common fallacy that land rent alone 
is truly rent, and house rent and other rent are really 
interest. It is easy to see that land rent may be equal to 
interest on the capital-value of the land just as truly as 
house rent may be equal to the interest on the capital- 
value of the house. In that case both are rent and both 
are interest ; they are simply two different ways of measur- 
ing the same income-value. Rent is value-productivity ; 
interest is value-return. We know that the value of income 
from any source may be expressed relatively either to 
quantity or to the value of that source. Rent is expressed 
in the first way ; interest, in the second. 

Let us suppose a quantity of land — ten acres — to have 
a value of $1000, and that $50 a year is paid for its use. 
This $50 is both rent and interest. It is the rent on the 
ten acres and the interest on the $1000. The rate of rent is 
$50 per year for 10 acres, or $5 per acre per annum. The 
rate of interest is $50 per year for $1000, or five per cent per 
annum. In precisely the same way, let us suppose a quan- 
tity of houses — ten houses — to have a value of $100,000, 
and that $5000 a year is paid for their use. This $5000 is 
both rent and interest. It is the rent on ten houses and 
the interest on $100,000. The rate of rent is $5000 per 
year for ten houses, or $500 per house per annum, and the 
rate of interest is $5000 per year for $100,000, or five per 
cent per annum. 

The erroneous belief that land bears only rent, and that 
other instruments bear only interest, is to a large extent 
responsible for the narrow definitions of capital which 
are so often given and which are so framed as specifically 
to exclude land. A true analysis justifies the usage of 
business men who apply the term " rent " as freely to in- 
come from houses as to income from land, and the term 
" interest " as freely to income from land as to income from 
houses. 



392 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

§ 4. Four Forms of Income : Interest, Rent, Dividends, 
and Profits 

If now we gather together what was said in regard to 
explicit and implicit rent and the relations between rent 
and interest, we shall see that there are four chief forms in 
which men receive income from capital. These are ordi- 
narily known as interest, rent, dividends, and profits. 
These are the four great ways in which income is received 
by the owners of capital. In order to see them clearly, let 
us suppose four brothers, each of whom inherits a fortune of 
$100,000. The first invests his $100,000 in a land com- 
pany in $1000 bonds at par bearing five per cent interest. 
He then receives $5000 a year, which is interest in the narrow 
or explicit sense of the term. The next brother invests his 
$100,000 in a ranch of a thousand acres, which he rents to 
a tenant for $5 an acre. He then receives an income of 
$5000 a year, which is rent in the narrow and explicit sense. 
The third brother invests his $100,000 in a hundred shares 
of stock in a land company, buying it at par, or $1000 per 
share. This stock we shall assume yields him five per cent, 
and he receives an income of $5000 in dividends (also called 
profits). The fourth brother invests his $100,000 in a 
ranch of a thousand acres, which he proceeds to operate 
himself. Supposing that he succeeds in securing a net 
income of $5 per acre, he will be receiving $5000 a year of 
profits. Each of these brothers is receiving an income of 
$5000 a year from capital in the form of real estate; but 
they are all receiving their income under different conditions. 

The four types of income may be arranged as follows : — 

(1) Interest per cent. (3) Dividends (or profits) per cent. 

(2) Rent per acre. (4) Profits per acre. 

In the upper line, namely for brothers (1) and (3), the in- 
come is expressed as a percentage of the value of the capital. 
In the lower line the income is expressed per acre. As we 



Sec. 4] INCOME FROM CAPITAL 



393 



have seen, either expression can be translated into the 
other. Again the first column, namely for brothers (1) and 
(2), represents the explicit or assured income, while the 
second column, for brothers (3) and (4), represents the im- 
plicit or uncertain income. The first two brothers have an 
assured or stipulated income of $5000. The last two have 
an uncertain or precarious income which, though we have 
supposed it to be $5000, may, and probably will, fluctuate 
from time to time. There is a fundamental difference 
between the first two and the last two brothers in regard 
to the risk involved. The first two are supposedly relieved 
of risk, some one else assuming the risks of managing the 
land of the company or of running the ranch, and guaran- 
teeing to these brothers a fixed stipend of $5000 a year 
each. 

It is evident that some one must assume these risks. 
Uncertainty attaches to the future product because we 
can never know absolutely the conditions as to weather- 
blight, fire, labor conditions, etc. Nature never offers a 
perfectly safe investment. What is called a safe investment 
is always in the form of a contract between one man and an- 
other by which one man takes risks and guarantees another 
man against risks. Even then the guarantee is not perfect, 
so that the most " gilt-edged security " involves a slight 
element of risk, while in many cases little dependence can 
be placed upon a guarantee because of the unreliability of 
the person making it. 

Nevertheless, it remains true in a general way that ex- 
plicit income promised to the holder of a note or bond is 
comparatively certain, while the income to a stockholder is 
uncertain. Investors, therefore, are naturally divided into 
two groups : those who are unwilling to assume the risks 
of business, or bondholders, and those who are willing to 
assume these risks, or stockholders. Most modern enter- 
prises are financed by both of these two classes of investors, 
part, often half, being owned by the bondholders and the 



394 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

remainder by the stockholders. As we have seen in the 
study of capital accounts, the stockholders' share is the 
residuum after the value of all other obligations is de- 
ducted; and this residuum acts as a sort of a buffer or 
guarantee that the assets shall cover the liabilities. The 
smaller the fractional part assumed by the stockholders, the 
less adequate is this margin or guarantee and the greater 
the risk of large losses to the stockholders or even of com- 
plete bankruptcy. Therefore, in any proper financiering of 
an industrial project, care should be taken to provide that 
enough of the first cost should be paid by stockholders to 
fully guarantee the bonds. Exactly what constitutes a safe 
proportion will depend on the particular circumstances of 
the business. Experience, however, has determined certain 
fairly definite proportions which for stocks and bonds of 
different enterprises should be ascertained by the intending 
investor before entering into any particular project. 

The question now arises : What determines the rate at 
which the risk takers in a business, those who receive 
dividends and profits, shall be rewarded? Will all four 
brothers normally receive the same income? To this our 
answer is, first, that those who assume risk may receive 
either a larger or a smaller income than those who do not, 
and probably over a long period of time will receive a fluctu- 
ating instead of a steady income. Probably on the average 
the risk takers will receive a larger income than those 
guaranteed against risk ; for risk is, or should be, regarded 
as a burden and will not be undertaken unless the chance 
of unusually large returns outweighs the risk of unusually 
small ones. The daring spirits who assume the risk of 
embarking their capital in ships, railways, and other enter- 
prises and guarantee to their fellow-investors, the bond- 
holders, a fixed return, not only deserve, but in general 
receive, a higher return. Those who voluntarily assume 
risks, as the stockholder, do so not because they like the 
chance of taking risks, but because they hope in the long 



Sec. 5] INCOME FROM CAPITAL 395 

run to be sufficiently rewarded for so doing. They may, 
of course, be disappointed where bad luck has been un- 
usually persistent or where the investors have been unusu- 
ally sanguine and lacking in caution. 

At the extreme of incaution are the gamblers and reck- 
less speculators to whom a small chance of great gain out- 
weighs a great risk of moderate losses ; and where men of 
this temperament predominate, as is often true in mining 
camps, the average profits or dividends are apt to be less 
than the interest and rent which the cautious, conservative 
investor receives. 

§ 5. Avoidance of Risk 

Uncertainty being regarded as an evil by practically all 
normal persons, there is a constant effort to avoid or 
reduce uncertainties of income. Not only do bondholders 
avoid risks by shifting them to other persons, but those 
who thus assume risks also strive to reduce them to a mini- 
mum. This they accomplish in various ways, of which the 
following are important : (1) by increasing their knowledge 
of the future, (2) by employing safeguards against mis- 
chances of various kinds, (3) by insurance, (4) by " hedg- 
ing." We shall take these up in order. 

(1) Risk, being simply an expression for human ignorance, 
decreases with the progress of knowledge. The chief lines 
of progress in industry at the present time may be said to 
be those which tend to lift the veil which hides the future. 
Countless trade journals exist principally to enable their 
readers to forecast the future more accurately than they 
otherwise could. This the journals accomplish by supply- 
ing data as to past and present conditions, as well as by 
instructing their readers in the relations of cause and effect. 
Our government weather bureau supplies weather forecasts 
which greatly reduce this form of uncertainty of the farmers. 
For this and other reasons, farming, which until recently 



396 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

was one of the most uncertain of occupations, has come to 
be almost, if not quite, as amenable to fairly safe predic- 
tions as industry or commerce. Government reports of 
crop conditions and information as to diseases of plants and 
animals tend in the same direction. Again the prediction 
as to the amount of ore to be obtained from a mine and 
the cost of obtaining it is to-day far less uncertain than ever 
before. Whereas formerly the mining prospect consisted 
of wild statements of the ore " in sight," and the time and 
cost required to mine it, to-day the graduate of a mining 
school can, through his knowledge of economic geology and 
metallurgy, make forecasts with some degree of certainty. 

(2) Safeguards of many kinds have been invented to 
reduce the risk of shipwreck, fire, explosion, burglary, etc. 
A modern ship is built in compartments as a safeguard 
against shipwreck ; fire escapes are a safeguard against fire ; 
safety valves against explosions; and burglar alarms and 
safety deposit vaults against burglary. 

(3) Insurance consists in consolidating risks, i.e., in off- 
setting one risk by another by consolidating in one insurance 
company a large number of chances. Relative certainty 
is, as it were, manufactured out of uncertainty. Insurance, 
unlike increase of knowledge and safeguards, does not 
directly decrease the risks for society as a whole, but by 
pooling these risks it has the effect of steadying the income 
of individuals and spreading the burden of risk more evenly 
over all. The owner of a house would receive, if it were 
not insured, a net annual income of, let us say, $500 until 
the house was burned, after which he would suddenly find 
himself without any house to have an income from ; whereas 
if he insures, he will be receiving annually an income slightly 
less than before because of the insurance premium he will 
have to pay; but when a fire occurs, he will receive an 
indemnity enabling him to restore the house and continue 
his income almost unabated. The same method of steady- 
ing one's income is obtained by marine insurance, steam- 



Sec. 5] INCOME FROM CAPITAL 397 

boiler insurance, burglar insurance, plate-glass insurance, 
live-stock insurance, hail and cyclone insurance, accident and 
fidelity insurance, employers' liability insurance, and even 
life insurance. If a wife holds insurance on her husband's 
life, she avoids the evil, when widowed, of being left rela- 
tively destitute ; for the insurance provides her with an in- 
come which is a partial substitute for that formerly received 
from her husband. He and she prefer to sacrifice a yearly 
premium during his lifetime to avoid the risk of the sudden 
complete loss of income at his death. In short, the effect 
of pooling risks through insurance frees the individual of 
the large fluctuations in income which he would otherwise 
suffer. The income of society fluctuates less, relatively 
speaking, than that of the individuals composing society. 
This is true because the evils which form the extraordinary 
catastrophes in lives constitute a regular stream of events. 
Death in a family is an unusual catastrophe, but the num- 
ber of deaths in a community form a regular and predict- 
able series of events. To the owner of only a few vessels 
the shipwreck of one of them is an extraordinary catastrophe, 
but the shipwrecks of the world constitute a regular and 
predictable series of events. The same is true of accidents 
and mischances of all kinds. They are irregular for the 
individual and regular for society. When, therefore, society 
combines through insurance companies and otherwise con- 
solidates these risks, the individual gains an advantage by 
securing greater certainty and regularity in his individual 
income, even though the average income of the individual is 
not increased at all and is even decreased by the cost of 
conducting the insurance companies. 

In this last connection it should be agreed that insurance 
indirectly leads to the reduction of risk ; for insurance com- 
panies find it to their interest to reduce the risk against which 
they insure. Marine insurance companies expect the ships 
to secure the installation of safety devices. Fire insurance 
companies do likewise, and to-day even life insurance com- 



398 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

panies are beginning to advise their policy holders how to 
reduce the chance of death. 

In view of all that has been said, it is evident that insurance 
is one of the grandest of human devices in the warfare against 
risk. 

(4) It seems at first to be a curious fact that speculation, 
although dealing in chances, may be used to reduce chance to 
some persons who use it for this purpose. We have already 
seen how short selling reduces the risk to the person sold to. 
A building contractor when taking a large contract was 
asked whether he was not taking a large risk, since he could 
not know in advance what the costs would be. He replied, 
" No, I am taking no risks at all except on ' labor ■ ; I have 
made contracts to be supplied with material when needed 
at fixed prices." In other words, dealers had sold him future 
building materials " short." They had each assumed the 
risk of fluctuation in those special materials in which they 
dealt, thus relieving the contractor of the necessity of in- 
forming himself of the special market conditions on stone, 
brick, timber, etc. Similar results follow from short sales 
of wool to the woolen manufacturer previously cited in 
another connection. 

An important method of shifting risks is " hedging," 
whereby a dealer, for instance in transporting wheat, may 
be relieved of the risk of a change in price. He buys wheat 
in the West intending to ship it to New York and sell it there 
at enough to cover cost of transportation and a small profit. 
In consequence of a sudden fall in price he might find all his 
profit wiped out ; or he might, on the other hand, by a rise 
in price, make much more than normal profits. But, being 
of a cautious disposition, he prefers an intermediate course 
— a small profit which is sure, rather than the chances of 
both gain and loss. Consequently he " hedges." He 
enters into some speculative market, knowing that it will 
move in sympathy with the New York market, and there 
he " speculates " for a fall, or sells " short." In case the 



Sec. 5] INCOME FROM CAPITAL 399 

price in New York falls, what he loses on the wheat which 
he has transported he gains through his speculative short 
selling. Contrariwise, if the price rises, what he gains on 
his wheat transported he loses in the speculative market. 
In other words, he is, as it were, betting on both sides of the 
market at once, and therefore eliminating all risk, so that he 
only obtains his normal profit, commission, or percentage 
on the actual wheat handled, having imposed the burden of 
risk of speculation on the speculative dealers to whom he 
sells short. 

Now it is evident that the effect of the short sales we have 
mentioned and of hedging is to shift the risk from those less 
able and willing to those more able and willing to bear it. 
Those grain merchants who hedge, for instance, are relieved 
of a big risk which they would suffer if they did not hedge. 
Thus, strange as it may seem, they run less risk by speculat- 
ing through " hedging " than by not speculating at all ; and 
as they thus reduce the risk of their business they are en- 
abled to reduce their margin of profit. Consequently, the 
public in the end receives a benefit in cheaper grain. The 
case is thus very similar to that of the builder and the woolen 
manufacturer. Short selling, binding the future and the 
past, enables the student of special risks to guarantee the 
future to the general public. Risk is one of the direst eco- 
nomic evils, and all of the devices which aid in overcoming 
it — whether increased guarantees, safeguards, foresight, 
insurance, or legitimate speculation — represent a great 
boon to humanity. 

If risk could be completely eliminated, the profit of the 
stockholder would be more certain and steady and would 
average the same rate as the returns of those who receive 
explicit interest and rent. But, although there is a continual 
effort and tendency to reduce and consolidate risks, we can 
never expect in this world absolute certainty, and, as long as 
risks exist, there will be an important practical distinction 
between the income received in explicit interest and rent by 



4-00 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XXIII 

such persons as the first two brothers and the profits and 
dividends received by those represented by the last two 
brothers. The former will always receive a steady but 
certainly small income, while the latter will receive a fluctu- 
ating but, on the average, large income. 



CHAPTER XXIV 

INCOME FROM LABOR 

§ i. Similarity of Rent and Wages 

We have seen that income always has a source, and that 
this source is either capital or labor. We thus have two 
great agents in the production of income, labor and capital. 1 
The income from capital we have called "rent." The income 
from labor is called " wages." 2 

Corresponding to the distinction between explicit and 
implicit rent, we may distinguish between explicit and im- 
plicit wages, explicit wages being actual wages paid to a 
hired person, called the employee, by the person hiring him, 
called the employer ; and implicit wages being the earnings 
of a person who does not sell his services, but enjoys them 
himself. Such a person we have already called an enter- 
priser. 3 The earnings which the enterpriser secures ( so far 
as he secures them by working as an enterpriser) are called 
enterpriser's profits. 

1 As has been previously stated, " capital " is used in this book to in- 
clude land. Land is so important and peculiar a kind of capital that many 
writers prefer to make of it a special category and therefore to distinguish 
three agents of production — labor, land, and capital. It is also common 
to restrict the term " capital " still further by excluding goods in the hands 
of consumers or by other restrictions. The terminology here adopted is 
believed to be the most serviceable and also to conform more closely than 
most other textbook terminologies to the usage of business men. 

2 The term " wages " is here used to include those forms dignified as 
" salaries." The usual distinction between wages and salaries is merely 
one of degree, and has no scientific significance. 

3 Sometimes the French term " entrepreneur " is used. The English 
equivalent " undertaker," meaning one who undertakes an enterprise, was 
formerly in vogue, but has fallen into disuse because of its special applica- 
tion, now so common, to funeral directors. 

2D 40I 



402 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

The income of a community may therefore be classified 
into rent and wages, and each of these subdivided into 
explicit and implicit classes. We thus have four great 
branches of income — explicit rent, explicit wages, capital- 
ists' profits, and enterprisers' profits. 

Moreover, since the income included under capitalists' 
profits may be measured with reference to the value of the 
capital producing this income, they may be regarded also as 
interest, either explicit or implicit. 1 This is often the natu- 
ral and most convenient mode of expressing the income 
from capital, particularly when the ownership of capital 
is divided up among bondholders or stockholders. The 
usual method of .comparing the income of a stockholder or 
bondholder with the capital he owns is by stating that in- 
come in terms of some value of that capital, whether that 
value be market value or a nominal or original " par " value. 

Practically, therefore, we may divide the income of a 
community into six main parts simply by separating out from 
rent, whether explicit or implicit, the part which is reckoned 
in terms of the value of capital, i.e., that part which is in- 
terest, whether explicit or implicit. While it is true that all 
rent may be translated into interest, only part of rent is, in 
the actual world of business, so expressed. We therefore 
find in the modern world six great branches of income con- 
sidered in reference to the source from which it comes. 
These are commonly called wages and enterprisers' profits, 
rent and capitalists' profits, interest and dividends. The first 
pair are measured per man, the next pair per acre or other 
physical unit of capital, and the last pair as a percentage of 
capital-value. All six branches of income may be arranged 
as follows : 2 — 

1 In order to make a corresponding measurement of wages, we should 
need to appraise the value of free human beings. As this would be both 
difficult and of little practical use, it will here be disregarded. 

2 The classification of income here given corresponds closely to that of 
business men, but differs somewhat from that in most other textbooks. 
A very common textbook classification of income divides it into rent, 



Sec. i] INCOME FROM LABOR 403 

Explicit Implicit 

P P . 1 I Interest per cent f Profits per cent 

^ I Rent per acre [ Profits per acre 

From Labor Wages per man Profits per man 

The principles governing the rate of wages are, in a gen- 
eral way, similar to those governing the rate of rent. The 
rate of a man's wages per unit of time is the product of the 
price per piece of the work he turns out multiplied by his 
rate of output in that time. His productivity depends on 
technical conditions, including especially his size, strength, 
skill, and cleverness, while the price per piece of his services 
depends upon the general principles of supply and demand 
as already stated. 

The productivity of any capital, whether human or ex- 
ternal, will differ with the capital. Men differ in quality, 
i.e., in productive power, as truly as lands or other in- 
struments differ. Some men have a high degree of earning 
power and some have not. Some men can work twice as 
fast as others. Some men can do higher grades of work 
than others. The result is that we find men classified as 
common manual laborers, skilled manual laborers, common 
mental workers, superintending workers, and enterprisers, 
or men who take important initiative in conducting indus- 
trial operations. Just as we can measure the rent of any 
land by the difference in productivity between that and the 
low-rent, or no-rent, land, in exactly the same way we 
can measure the difference in productivity between men. 

wages, interest, and profits. Of these four terms " wages " is generally em- 
ployed in the same sense as in this book. But the terms " rent " and 
" profit " are usually employed in other senses. Thus the term " rent " 
is usually restricted by economists to income from land. It excludes, for 
instance, the rent of houses. The term " profits " is used in many different 
senses, but is often restricted to enterprisers' profits. 

The student of economics needs to accustom himself to study carefully 
the terminology of each economic writer. Otherwise the conflict among 
these writers and the discrepancy between most of their concepts and the 
usage of business men may be found confusing. 



404 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

There is no grade of workmen called the " no-wages men," 
but there would be such a grade if it were customary for 
their employer to pay for their cost or support (as the 
employer of land pays for its cost), so that only the 
excess above this cost were to be called wages. There 
are, indeed, men so incompetent that their net earning power 
is nearly zero, and they can barely earn enough to support 
themselves. These incompetents may be unfortunates, as 
in the case of invalids and imbeciles, or guilty of laziness, 
as in the case of indolents. But whatever the cause 
may be, they correspond in economic analysis to no-rent 
land. 

§ 2. Peculiarities of Labor Supply 

But owing to the fundamental fact that a laborer, 
unlike any other instrument, is owned by himself and 
not, except in slavery, by another, there are certain 
peculiarities of wages as compared with rent. These 
peculiarities lie in the supply curve. We shall note four 
cases. 

In the first place, the supply curve of human services 
ascends very rapidly and often even " curls back," as pre- 
viously explained. This peculiarity, as we saw, was due to 
the fact that a man's desire for more money (marginal de- 
sirability of money) decreases rapidly with an increase of 
his earnings. Beyond a certain point the more he is paid, the 
less he will work. We may state the same fact in the re- 
verse direction, and say that under certain circumstances 
the less a man is paid, the harder he will work. The shape 
of his supply curve will depend in very large measure on 
whether or not he has other sources of income besides his 
work. Figure 47 exhibits this fact. 

The curve SS'S" represents the supply curve of work 
for a rich man who has income from other sources than his 
work, and the curve «V that for a poor man, who has to 



Sec. 2] 



INCOME FROM LABOR 



40S 



depend on what he can earn. The rich man will not work 
at all for any wages below a certain price, say $1 an hour, 
represented in the diagram by OS. Any price above this 
will induce him to work a little. Thus for $1.20 an hour he 
will work about 
two hours ; for 
$1.40 an hour, 
about three and 
one half hours ; 
and for $2 an hour, 
about five hours. 
But if the price ex- 
ceeds a certain 
height, S', repre- 
sented in the dia- 
gram as $2 an 
hour, the result 
will be that he will 
work less rather 
than more. These 
relations corre- 
spond with ob- 
served facts. A millionaire will not work for a day laborer's 
wages. He may work a few days in the year for $100 a day, 
and work more days for $500 a day, but $1000 a day may 
lead him to work fewer days, and devote more time to vaca- 
tions and to enjoying his large income. 

The poor man will be guided by similar considerations. 
His curve will be lower vertically, but wider horizontally — 
if the measure of work in each case is in hours of work. 
Owning little or nothing besides his person, he cannot afford 
to be idle. Unemployment for him is seldom voluntary. 
So long as he can get a price for his work sufficient to keep 
him out of the poorhouse, he will work for that price. 
Thus, the minimum price which is necessary to induce 
him to work rather than become a tramp or beggar is repre- 




5 6 7 8 9 IO ti 

hours 

Fig. 47- 



406 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

sented in the diagram by Os, the very small sum of ten 
cents an hour. We note that it takes only a relatively 
slight rise in that price to induce him to work a full day. 
The height of s' represents the price at which he will work 
the greatest number of hours. Above this he will prefer 
slightly shorter hours. As already stated, it is probable that 
the eight-hour movement to-day is partly due to the fact 
that wages are high enough to enable the laborer to afford 
some leisure instead of being so low as to " keep his nose 
close to the grindstone." 

A reduction in wages works in the opposite way, making 
workmen willing to work longer hours. Only when the price 
falls much below the elbow at / will they refuse longer to 
endure the low wages and long hours. They will then pre- 
fer, if not to starve, to throw themselves upon the mercy and 
charity of the community. The general level of the curve 
between the elbow s' and the beginning s represents their 
minimum standard of living which they require if they work 
at all. 

Now, if wages keep high and the workmen have a suffi- 
ciently low " rate of impatience " to enable them to accumu- 
late savings, they become more " independent," which, as 
applied to their - supply curve sn" means that it shifts a 
little toward the rich man's supply curve SS'S". The 
result is a higher minimum wage necessary to induce the 
laborer to work and a lower maximum number of hours 
which he is willing to work. The intersection with the de- 
mand curve will therefore tend to be higher and farther to 
the left ; that is, the market rate of wages will tend to be 
higher and the hours worked to be fewer. 

This result is not due to any reduction in the number of 
workmen, but simply to a reduction in their desire for more 
money. Savings, therefore, making workmen more inde- 
pendent and less necessitous, will — by lessening their desire 
for money — both increase their wages and shorten their 
hours. 



Sec. 2] INCOME FROM LABOR 407 

A second peculiarity in regard to wages is that, except 
under slavery, the earnings of a laborer are seldom dis- 
counted for the purpose of ascertaining his capital-value. 
The reason for making an appraisement usually has refer- 
ence to some proposed sale ; and, as working men and women 
are no longer for sale, their capital-value is seldom com- 
puted. For this reason, wages, unlike rent, are not often 
regarded in the light of interest on the capital-value of the 
men who earn them. 

A third peculiarity of wages is one already alluded to, 
viz., that in practice they are always reckoned as gross and 
never as net. This is because the wages are reckoned from 
the standpoint of the employer who pays them, and not of 
the laborer who receives them. Under slavery the case was 
different, and the net income earned by a slave was com- 
puted in the same way as the net income earned by a horse 
— by deducting from the value of the work done the cost of 
supporting the slave. But under the system of free labor 
which now prevails, the employer has no such cost. The 
laborer assumes his own support, and furnishes only his 
work to the employer. The net wages of the laborer, if 
they are to be computed at all, are to be found by allowing 
for the irksomeness of his work, i.e., the real costs which he 
bears of labor and trouble. At the margin — i.e., for the 
last unit of work done — this cost is, as we have seen, equal 
to the wages received for. it ; but on all earlier units of work 
there is a gain of desirability which can be appraised in 
money. The net wages thus reckoned will be only a part 
of the wages as ordinarily quoted. 

When, therefore, we compare the S500 a year which a 
workman gets by selling his work with the $500 a year 
which a bondholder gets as interest, we must not forget 
that the workman's $500 is really less valuable than the 
bondholder's $500, and for two reasons. One is the reason 
just given, that the workman's S500 is obtained only by 
the sweat of his brow, while the bondholder's is all clear 



408 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

gain ; the other reason is that the workman's $500 will cease 
at his death or disablement, while the bondholder's goes on 
forever. 

A fourth peculiarity concerning wages is that the supply 
of wage earners differs from the supply of any other instru- 
ment. Except in slavery, workmen are not bred like cattle 
on commercial principles. A rise in the price of the serv- 
ices of a draft horse will increase the demand for draft 
horses, and the result will be that both the market price 
and the amount supplied at that price will be increased. 
Those who supply draft horses will breed them to take 
advantage of the higher prices of them and their services. 
A rise in the price of human services will not act so simply. 
It is true that a rise in wages usually increases the number 
of marriages and often increases the birth rate, but such is 
not always or necessarily the result ; and even when births 
do increase in number, they do not increase to exactly the 
same extent as the draft horses. It is an exceptional 
father who can think or say as did a cynical old farmer 
who had raised a large family and thriftily turned their 
child labor to early account for his own benefit : " My 
children have been the best crop I ever raised." Ordinarily 
parents view their children not as potential earning power, 
but as objects of affection, and either do not attempt to 
regulate their numbers, or do so with reference to considera- 
tion for their own or their children's comfort. The prin- 
ciples which regulate the number of laborers are part of the 
principles regulating population in general, and will be con- 
sidered in the next chapter. 

§ 3. The Demand for Labor 

Turning now from the supply to the demand side of the 
market, we find that the demand of employers for workmen 
is in general quite analogous to their demand for the services 
of land or any other productive agent. Sentiment and 



Sec. 3] INCOME FROM LABOR 409 

humanity have a little influence, but not enough to require 
special attention on our part. Wages are paid by the or- 
dinary employer as the equivalent of the discounted future 
benefits which the laborer's work will bring to him — the 
employer — and the rate he is willing to pay is equal to the 
marginal desirability of the laborer's services measured in 
money. We wish to emphasize the fact that the employer's 
valuation is (1) marginal, and (2) discounted. The em- 
ployer pays for all his workmen's services on the basis of the 
services least desirable to him, just as the purchaser of coal 
buys it all on the basis of the ton least desirable to him ; he 
watches the " marginal " benefits he gets exactly as does 
the purchaser of coal. At a given rate of wages he " buys 
labor " up to the point where the last or marginal man's 
work is barely worth paying for. This marginal unit of 
work is a sort of barometer of wages. The employer's 
problem in buying labor is the same as the householder's 
problem in buying coal discussed in a previous chapter. He 
is constantly balancing in his mind the desirability of the 
work of his employees against the desirability of the wages 
he pays for that work. If, say, he decides on one hundred 
men as the number he will employ, this is because the hun- 
dredth or marginal man he employs is taken on because his 
work is believed to be barely worth his wages, while the man 
just beyond this margin, the one hundred and first man, is 
not taken on because his work is believed to be not quite 
worth his wages. 

Secondly, wages which the employer pays are the dis- 
counted value of the future benefits he receives. Thus, the 
shepherd hired by the farmer to tend the sheep in the pas- 
ture renders benefits the value of which to the farmer is esti- 
mated in precisely the same way as the value of the benefits 
of the land which he hires. To take another example, sup- 
pose a landowner is contemplating the planting of 10,000 
trees which he believes will be worth as lumber in twenty 
years about $10,000, or one dollar per tree planted. His 



4IO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

problem is : How much is it worth his while to pay per tree 
for the planting? The answer depends on the rate of in- 
terest. If this is three and a half per cent, it is worth his 
while to pay 50 cents per tree planted, for the present value 
of $1 discounted for twenty years at three and a half per 
cent is $1 4- (1.03I) 20 , which is 50 cents. As some trees may 
require more and some less labor, the landowner will limit 
his tree planting at that point or margin where the cost of 
the labor amounts to about 50 cents per tree. It follows 
that the rate of wages, like the rate of rent, is dependent (on 
the demand side of the market) upon the rate of interest. 

A rise in the rate of interest will tend to produce a fall in 
the rate of wages by lowering the discounted value of the 
final benefits from the work of laborers, and therefore lower- 
ing the prices which employers are willing to pay. Con- 
trariwise, a fall in interest produces a rise in wages. Thus 
if the rate of interest in the case of the landowner planting 
trees rises from three and a half per cent to six per cent, he 
can no longer afford to pay 50 cents per tree for the sake of 
getting back a dollar's worth of lumber in twenty years; 
for $1 discounted at six per cent for twenty years is worth 
only 31 cents. Consequently, the prospective landowner 
will diminish his demand for tree planters, and their wages 
will fall. 

In a previous chapter we have seen that, the value of 
capital being the discounted value of future uses, a rise or 
fall in the rate of interest produces a fall or rise, respectively, 
in the value of capital, and that the more remote the future 
uses, the more pronounced is the effect of a change in the 
rate of interest. 

Conformably to this reasoning, the dependence of wages 
on the rate of interest is the more pronounced, the more re- 
mote are the ultimate benefits to which the work of the 
laborer leads. In a community where the workmen are 
largely employed in enterprises requiring a long time, such 
as digging tunnels and constructing other great engineering 



Sec. 4] INCOME FROM LABOR 411 

works, the rate of wages will tend to fall appreciably with a 
rise in the rate of interest, and to rise appreciably with a fall 
in the rate of interest ; whereas in a country where the 
laborers are largely engaged in personal service or in other 
work which is not far distant from the final goal of enjoy- 
able benefits, a change in the rate of interest will affect the 
rate of wages but slightly. 

Moreover, a change in interest will divert laborers from 
one employment to another. If interest rises, it will divert 
labor from enterprises which require much time and in which, 
therefore, the high interest is a serious consideration, and 
turn it into enterprises which yield more immediate bene- 
fits. For example, the higher the rate of interest, the less 
relatively will laborers be employed in planting slow-grow- 
ing trees, and the more relatively will they be employed as 
domestic servants, and vice versa. 

We have now considered wages under conditions of com- 
petition. Under competition they are determined — like 
any other competitive price — by the familiar principles of 
supply and demand. If, instead of competition, we have 
conditions of more or less perfect monopoly, the principles 
of wage determination will change accordingly and in the 
manner previously explained for monopoly. If employers 
form combinations called trusts, or if laborers form combina- 
tions called trade-unions, there will be an effect on the rate 
of wages. These combinations tend to render bargaining 
collective instead of competitive, and the efforts on the two 
sides of the market take the form of struggles called strikes 
and lockouts. The fuller consideration of these subjects 
belongs to applied economics. 

§ 4. The Efficiency of Labor 

We have seen how the price of the laborer's services is 
determined. But the total income of a workingman will 
depend not only on the price he receives for each unit of 



412 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

work, but also on the number of units of work he turns 
out. His capacity to turn out work is called his efficiency. 
In general the greater the efficiency of workingmen, the 
greater will be the amount of real income they receive. 
This is perfectly obvious in the case of implicit wages, and 
every independent worker is so fully aware of it that he 
is constantly aiming to improve his own efficiency. The 
farmer, for instance, knows that the more work he can accom- 
plish in a day, the greater the income which he will enjoy. 
The more he can reap this year with a given expenditure of 
time and effort, the greater will be this year's income. He 
will, therefore, try to sow and reap as much as possible with 
a given amount of effort, or, in other words, to put forth as 
little effort as possible to accomplish a given amount of 
sowing and reaping. The more he can reap with a given 
amount of effort, the greater will be this year's income in 
relation to the cost or outgo ; and the more he can sow with a 
given amount of effort, the greater will be next year's in- 
come in relation to this year's outgo. His problem is always 
to minimize labor and to maximize the product of labor, 
and his prosperity depends upon his so doing. 

The same principle applies, in general, to wage earners, 
even when their wages are explicit, since the products of 
their labor will, to a great extent, be consumed by other 
laborers. While the interests of workmen lie chiefly in 
increased wages, these wages can only be obtained by ren- 
dering adequate services. Wages are not the gift of the 
employers, but the product of the workmen's own exertions. 
To attempt to get great wages without rendering great 
services in return is to fight the best interests of other 
workmen, for, indirectly, workmen are all connected by 
trade. The more efficient the hired men on the farms in the 
West, the greater will be the wheat crop and the cheaper will 
be the bread bought by the employees in the shoe factories 
in the East; just as the more efficient the employees in 
the shoe factories in the East, the more abundant and 



Sec. 4] INCOME FROM LABOR 413 

cheaper will be shoes for the farm laborers in the West. 
It is, therefore, to the best interests of each workman that 
all other workmen should produce as much, and as eco- 
nomically, as possible. Moreover, while a workman may 
temporarily injure his employer by a policy of wastefulness, 
in the long run the employer will recoup himself for such 
wastefulness by charging higher prices for his products and 
thus raising the general cost of living. Thus in the end the 
wasteful workman injures himself and his fellow- workmen. 

We have seen, then, that for the ultimate prosperity of 
labor, it is of the utmost importance that workingmen should 
do the largest possible amount of work in the most efficient 
manner in a given time. The efficiency of laborers can be 
increased in three chief ways : first, by improvement in 
physical and mental vitality ; second, by improvement in 
trade education ; and third, by improvement in organization 
and division of labor. 

It is obvious that the more work a laborer performs under 
conditions which tend to impair his vitality, the greater will 
be the resulting injury to his prosperity and to that of the 
community of which he forms a part. The public is begin- 
ning to realize that there are many factors in a working- 
man's life which tend to lower his vitality and thus greatly 
to reduce his earning power. Some of these factors are 
due to his personal habits, some to the lack of proper pub- 
lic health regulations in the community in which he lives, 
and still others to certain conditions under which he works. 
Among the personal habits which are very harmful to the 
wage earner should be mentioned the use of alcoholic bev- 
erages. As employers are becoming more and more conscious 
of this fact, they are beginning to require temperance and 
sometimes total abstinence of their employees, particularly 
when those employees occupy positions which make them 
responsible for the safety of property and of lives. Sea cap- 
tains, locomotive engineers, and those charged with convey- 
ing telegraphic signals are often required to be total abstain- 



414 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

ers, and this requirement is being constantly extended to 
other classes of labor. Wrong habits of diet among work- 
ingmen are also often the cause of impaired vitality, and 
consequently of impaired efficiency. Some of these, such 
as the use of ill-balanced rations deficient in or containing an 
excessive amount of tissue-building elements, are the result 
of ignorance on the part of the workingman. Others, such 
as the use of injurious foods, like tuberculous meat, infected 
milk, canned foods containing harmful preservatives, while 
due in part to the ignorance of the workingman, are more 
largely due to the failure on the part of the lawmakers of a 
community to pass and to insist upon the enforcement of 
laws which shall prevent the sale of such foods. 

There are many other ways in which lack of proper laws 
and regulations in a community endangers the health of the 
workingmen of that community. Among these is exposure 
to infection from those having infectious diseases, whether 
among neighbors, fellow-employees, or children in school. 
Housing conditions are particularly objectionable and are 
at present the subject of much discussion and study on the 
part of social reformers. A recent investigation has shown 
that without increasing the expense to a community in the 
construction of houses for working people, it would be pos- 
sible to secure for them sanitary conditions far superior to 
those which they now ordinarily enjoy. 

Still other causes of the impairment of the laborers' 
vitality are certain conditions under which he works. The 
fight against excessively long working days, which is being 
carried on both by workingmen themselves and by others 
interested in their welfare, is gradually being won. Experi- 
ments of reducing the hours of labor from the present aver- 
age of about ten hours a day to nine hours, or in many cases 
eight, have often resulted in an increased productivity not 
only per hour, but per day. We are still suffering from the 
tradition handed down from the days of slavery when often 
the employer's whole effort was to " drive " his employees to 



Sec. 4] INCOME FROM LABOR 415 

the utmost of their capacity. In many trades to-day an ex- 
ample of this " driving " is seen in the " pace maker " or fast 
worker selected for his ability for very rapid work and em- 
ployed to set a pace for the other workmen. As laborers 
vary greatly in the rapidity with which they can turn out 
work, this struggle to live up to an excessive speed standard, 
while it may result temporarily in an increased output per 
man per day, often results ultimately in producing chronic 
diseases and in injuring the health of the men in other 
ways to such an extent that their future earning capacity 
is greatly impaired. 

Ordinarily, division of labor decreases the demand for 
education by restricting the amount of education which is 
needed. With specialization of work the amount of time 
necessary before a person can become a breadwinner be- 
comes relatively small. This makes it possible to enter a 
trade early in life. The advantages of organization and divi- 
sion of labor are very obvious and have often been em- 
phasized. It is quite as important that the student should 
understand the fact that mere specialization, while it fits 
the laborer for his special task, does not qualify him to meet 
the requirements of a world where industrial conditions are 
rapidly changing. The fact that specialization prevents 
a workman from being able to change from one occupation 
to another lies at the basis of the complaints against labor- 
saving machinery. Each new invention brings with it a 
readjustment of labor conditions and makes useless a great 
deal of special knowledge which was adapted only to the old 
conditions. For this reason many workmen lose their 
positions who are not qualified to adapt themselves to new 
employment. Probably the best results will be secured by 
combining special trade education and special trade experi- 
ence on the one hand, and general education and general 
trade experience on the other. The more the laborer can 
have of a general grammar school or even high school educa- 
tion, the more adaptable he will be ; and if at any time he is 



41 6 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

thrown out of his special employment by changes, he will 
have less difficulty in adapting himself to the new employ- 
ment which this change almost inevitably brings about. 

The importance of general education for the workman 
is widely recognized, but it is not yet realized that a certain 
amount of general experience is likewise valuable. If em- 
ployers could see an advantage in changing the tasks among 
workmen from time to time, it is probable that the tempo- 
rary loss from such changes would more and more be offset 
by the greater intelligence and efficiency of the workmen 
which would result. 

The full discussion of the methods of increasing efficient 
production by workmen belongs to applied economics, and 
if the student wishes to follow these important and interest- 
ing subjects, he will find them in books on Labor Laws, the 
Housing Problem, Public Health, Hours of Labor, Child and 
Woman Labor, Technical Education, Factory Sanitation, 
Workmen's Positions, Insurance, etc. 

§ 5. The " Make-Work " Fallacy 

Blindness of workmen and others to the fact that the 
greater the efficiency of workingmen, the greater their own 
ultimate prosperity, is sometimes responsible for the " make- 
work " fallacy. According to this erroneous belief, the 
welfare of workmen depends, not on their productivity, but 
on their having jobs. On this basis they advocate great 
public works by the state in order to "make work" for the 
unemployed. According to this philosophy, a snowstorm 
blockading a city is an advantage to workmen, as it " makes 
work " for the snow shovelers. If we carry this logic a 
little farther, we should have to conclude that it would be 
an advantage to workingmen to destroy the houses of a 
community in order to make work for carpenters ; to break 
windows in order to make work for glaziers; to burn up 
the stock of the clothier and the shoe dealer to make work 



Sec. 5] INCOME FROM LABOR 417 

for those employed in tailoring and shoe manufacturing ; 
and in general to destroy all products of industry in order 
to make more work for those who produce. We could go 
even farther and advocate that without waiting for a snow- 
storm to blockade the streets, a city could benefit its 
workmen by engaging them to shovel dirt from one side 
of the street to the other and then back again. 

The make-work fallacy consists in confusing the benefits 
of working with the products of work. Mere aimless work 
cannot in the end benefit workmen. To produce things 
merely to be destroyed, or to shovel dirt back and forth with 
no useful object, will in the end reduce and not add to the 
real wages of workingmen ; for it reduces the volume of the 
products of labor which constitute the real wages. If shoes 
and clothes are destroyed, the main effect will be not to in- 
crease wages of shoemakers and clothiers, but to make 
workmen in general go ill-shod and ill-clothed. To break 
windows or to destroy houses will, as its main effect, not 
increase the wages of glaziers and carpenters, but decrease 
the quantity and the quality of shelter which workmen 
enjoy. No matter how complicated the organization of 
society, we cannot get rid of the simple fact that our welfare 
depends on our producing the largest possible output at the 
smallest possible cost, thus maximizing the final satisfactions 
of life and minimizing the effort by which they are obtained. 
The type of economic production may be pictured by Robin- 
son Crusoe picking berries. He will not try to " make work " 
for himself by destroying the berries he has picked ; he will 
not try to limit the amount of berries he picks ; he will have 
none of the other fallacies which in modern complicated 
conditions workmen so often have. He will simply try to 
pick as many berries as he can with the least amount of effort 
and waste. Modern conditions of exchange and industry 
do not modify this essential relation between satisfactions 
and efforts. They do, however, obscure the relation and, 
as a result, lead to the make- work fallacy. This fallacy 



41 8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

vitiates a great deal of the reasoning employed by trade- 
unions and by the uninstructed public. It is very analo- 
gous to the money fallacies which have been previously 
discussed that confuse the mere medium of exchange with 
the goods exchanged thereby. It is almost as crude 
an error to suppose that workmen can be enriched by 
" making work " for them as that they can be enriched by 
issuing paper money. Work and money are merely means 
to an end. If we are to think clearly enough to rid our- 
selves of the money fallacy and the make-work fallacy, we 
must fix our attention on the end, and not on the means. 

One of the offsprings of the make-work fallacy is the 
policy of " protecting " a home industry against foreign 
competition. Thus the make-work fallacies, like the money 
fallacies, have been employed in aid of the protective fallacy. 
Whatever else of good may be said in favor of protection, 
the argument that it makes work for those employed in the 
protected industries is fallacious. The argument is quite 
analogous to the argument against labor-saving machinery. 
In fact, free trade may be thought of as a sort of labor- 
saving machinery, and the objections to free trade which 
many instinctively feel are quite analogous to the objec- 
tions which many workmen instinctively feel against labor- 
saving machinery. According to this argument we ought 
not to try to secure goods as cheaply as possible if by a 
greater expenditure of effort we can manufacture them at 
home ; for this home manufacturing will give employment 
to workmen. According to this argument, instead of im- 
porting woolen cloth from abroad, it is better to protect 
woolen manufacturers at home in order to " make work " 
for spinners, weavers, etc., in American woolen mills. Here 
again we come in contact with applied economics, and 
it is not within the scope of this book to discuss at length 
the pros and cons of protective tariff further than as it 
illustrates the make-work fallacy. 

One of the bases of the make-work theory lies in the 



Sec. 6] INCOME FROM LABOR 419 

assumption that unemployment can be artificially remedied 
by supplying jobs. Unemployment, however, is self-cor- 
rective. It has always occurred to a certain extent as an 
incident to changed conditions. In the crop season an extra 
corps of workmen is employed on farms, and for a short 
time thereafter all of them, and for a long time some of 
them, will be out of work simply because it requires time to 
find another job, and even to get to it if it has already been 
found and contracted for. With the great expansion and 
contraction of trade which we have discussed in previous 
chapters, there usually come corresponding changes in un- 
employment. Thus unemployment is a necessary incident 
to industrial change. It is undoubtedly an evil, and it is 
quite proper that every effort should be used to reduce it, 
but the plans of the make-work philosophy cannot in the 
end reduce, and might aggravate, it ; for employers will not 
continue to employ workmen merely for the sake of giving 
them a job. Unemployment does not need any artificial 
remedy, for it is its own natural remedy by increasing the 
supply of labor. In the particular directions where unem- 
ployment exists, the rate of wages in that employment rela- 
tively to other employments is reduced. This increases 
the demand for labor in that employment, and tends to give 
work to the unemployed. In other words, supply and 
demand automatically prevent any continued abnormal 
degree of unemployment. 

§ 6. Wages and Profits 

What has been said applies to income received through 
wages in general, including both explicit and implicit wages, 
but implicit wages or enterprisers' profits need to be more 
particularly considered. Profits are in practice seldom called 
wages ; for this term is usually employed in the narrow 
sense of explicit or stipulated wages. 

The peculiarity of profits lies in the element of chance. 



420 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

Stipulated wages are supposedly certain, while profits are, 
by the nature of the case, uncertain. Almost every worker 
has the option of hiring out to some one else or of being his 
own employer. In the former case he foregoes the chance 
of gain and the chance of loss. In the latter case he secures 
the chance of gain at the expense, however, of assuming a 
risk of loss. As a consequence, workmen classify them- 
selves into two groups — wage earners or employees in the 
narrower sense, and enterprisers or employers — entirely 
analogous to the two groups into which we have seen that 
capitalists classify themselves; namely, bondholders and 
stockholders. And just as the bondholders consist of those 
who wish to avoid chance and the stockholders of those who 
are willing to assume risks, so also the employees are those 
who wish to avoid chance and the employers those who are 
willing to assume risks. And just as the stockholder stands 
sponsor to the bondholder for a stipulated income from capi- 
tal, so the employer stands sponsor to the employee for a 
stipulated part of the income from labor — or usually from 
labor and capital jointly considered — as a consequence of the 
fact that those become enterprisers who believe themselves to 
be especially adapted to the responsibilities which their posi- 
tion involves. 

The employee or recipient of explicit wages does not 
usually require foresight in any great degree, while one of 
the chief functions of the profit taker or enterpriser is to 
make forecasts. Again, a man, in order to be an employee, 
does not require any accumulation of capital, while an en- 
terpriser is far better equipped for his position if he is the 
fortunate possessor of a considerable fund of capital. It 
therefore happens that while theoretically an enterpriser 
may have little or no capital, practically he is usually a capi- 
talist as well as an enterpriser. 

Profits stand in a double relation to (explicit) wages ; for 
the work of the enterprisers and the work of the wage earners 
are to some extent substitutes and to some extent mutually 



Sec. 6] INCOME FROM LABOR 421 

complementary. So far as these two kinds of work are sub- 
stitutes for each other, they compete, and the price of the one 
tends to correspond to the price of the other. If, for instance, 
wages of plumbers go down, it will often happen that a few 
enterprising plumbers, rather than take these low wages, 
will set up for themselves as independent plumbers and 
employ other plumbers at these low wages. The effect of the 
transfer of these men from the ranks of the employees to 
the ranks of the employers tends, on the one hand, by 
diminishing the supply of plumber employees, to raise 
their explicit wages, and, on the other, by increasing the 
supply of plumber employers, to diminish the implicit 
wages of the latter ; in other words, to diminish the dis- 
parity brought about by the supposed fall in plumbers' 
(explicit) wages. 

If, on the contrary, the wages of plumbers rise, it will 
often happen that the same or other men will move back 
from the ranks of employers to the ranks of employees. 
Finding that they can make only a small and precarious 
living as employers, either because there is too much com- 
petition among the independent plumbers or because of 
their own personal shortcomings or misfortunes, they now 
prefer to accept the high wages which plumbers are getting 
rather than to continue the fight any longer. 

There is a similar competition between the carpenter em- 
ployer and the carpenter employee ; in fact, between the 
" boss " and the man in every trade or walk of life. If there 
were no difference in abilities, there would be a tendency for 
wages and profits to be almost equal, although there would 
always be a slight difference in favor of profits owing to the 
fact that men in general regard uncertainty as an evil. Just 
as in general and normally a stockholder gets a higher aver- 
age return than the bondholder, so the profit taker will in 
general and on the average get a higher return than the wages 
guaranteed to the employee. 

But in actual life the difference in superiority of profits is 



422 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. XXIV 

still further increased by the fact that the enterprisers form 
a select class. While almost every enterpriser is capable of 
being a wage earner, not every wage earner is capable of 
being an enterpriser. Therefore the supply of enterprisers 
is always somewhat restricted. Moreover, enterprisers are 
also a select class in that they are capitalists. While the 
possession of capital is not always an absolutely necessary 
qualification for becoming an enterpriser, it is so great an 
advantage as very materially to limit the number of those 
best equipped to be employers. While the possession of 
capital does not prevent a man from being a wage earner, 
the lack of it tends to prevent his becoming an employer. 
This still further limits the supply of employers and tends 
to elevate still further their profits. In short, the employers' 
or enterprisers' profits tend to be high for three reasons : 
(i) because these persons assume risks and responsibilities 
which few are able or willing to take ; (2) because for that 
very reason qualities of foresight, courage, and exceptional 
ability which few possess are required ; and (3) because the 
work of the enterpriser usually requires, for its success on 
a large scale, the possession of capital. 

Partly as a consequence of these peculiarities of enter- 
prisers and partly, because of the general conditions of mod- 
ern industrial organization, the relation between employers 
and employees is not altogether or even generally competi- 
tive, but is to a large extent complementary. This relation- 
ship is in fact more obvious than the competitive relation- 
ship just described. The employer and the man in the same 
establishment do not stand to each other in a competitive, 
but in a complementary, relation. The work of each is 
necessary for the efficient work of the other. The enter- 
priser could not accomplish very much working merely by 
himself ; he requires for the best use of his abilities a large 
number of employees. Conversely, the employees cannot 
receive a guaranteed wage unless they find some employer 
who is willing to make the guarantee. The two stand in a 



Sec. 6] INCOME FROM LABOR 423 

relation similar to that existing between any two comple- 
mentary commodities, as, for instance, the relation of the 
engine to the train it draws. 

To the extent that enterprisers and wage earners are 
complementary, the earnings of the one tend to move not in 
unison with, but in opposition to, the earnings of the other. 
The lower the wages of the employee in any establishment, 
the more in general will be the profits of the employer, and 
vice versa. We see, therefore, that the relation between 
the employer and the employee is a complicated one, being 
partly competitive and partly complementary, and that 
their interests are largely opposed. The net result is usually 
that profits are far greater per capita than wages. 

But, while this is true of the average rate of profits, we 
must remember that, as the very nature of profits requires an 
element of chance, they vary enormously, and that in many 
instances the individual enterpriser may make less than the 
wage earner, or even less than nothing at all, while in other 
extreme cases he may make his fortune. 

To a large extent those who make fortunes are of more 
use to society than those who suffer losses. So far as the 
large fortunes are due to superior foresight, they represent 
the result of wise and beneficial leadership in industry. 
Commodore Vanderbilt was an enterpriser who foresaw the 
importance of transcontinental railways. As a consequence 
of his foresight and success, he not only founded a fortune 
for himself and family, but he developed for the country 
enormous producing and earning capacity. Many other 
similar examples could be given ; while at the opposite ex- 
treme could be mentioned men who have attempted un- 
successfully to build railways and have not only ruined 
themselves, but wasted the labor and capital of the commu- 
nity. The enterpriser who receives profits is like the specu- 
lator previously mentioned ; for both, success means, in 
general, benefit to the community. Just as it is a mistake 
to condemn speculators in general, so it is a mistake to con- 



424 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

demn successful enterprisers who have accumulated fortunes 
by the use of their talents. 

It is, however, also true that just as there are types of 
successful speculators which should be condemned, so there 
are types of successful enterprisers which should be con- 
demned. Those clever promoters who gain at the expense 
of the public through the frauds of " high finance " are 
among the worst forms of public enemies. 

Hitherto we have spoken separately of the capitalist who 
is a profit-taker and of the enterpriser who is a profit-taker, 
but, as has been indicated, usually one and the same person 
is both capitalist and enterpriser. The distinction between 
the two is the distinction between those who receive income 
from their capital only and those who receive income from 
their work only, but usually the two are combined, and this 
is especially true when the income consists of profits. Those 
who wish to receive income through their capital without 
any work become bondholders rather than stockholders; 
while those who wish to get income from their work without 
investing (or perhaps even possessing) capital prefer to work 
for wages or salaries. If a man wishes to become a stock- 
holder, he usually is sufficiently actively interested to do a 
certain amount of work, if it is no more than investigating 
the relative prospects of different companies offering chances 
for investors. And it is still truer that those who wish to 
take the responsibility of conducting an enterprise wish not 
only to put their effort into it, but their capital also. 

It thus usually happens that the profits which a man 
receives cannot be easily classified into profits from his 
capital and profits from his own exertions. Generally his 
profits are the joint product of both his labor and his capital. 
We must therefore distinguish between three forms of profit : 
profits of capital, best typified by the dividends of the stock- 
holder ; pure profits of work, best typified by the income of 
the small " boss " without capital ; and mixed profits from 
both sources, the common and most important type. 



Sec. 7I INCOME FROM LABOR 425 

§ 7. General Influences on Rents and Wages 

The sum of all the rents and wages, explicit and implicit, 
in any community is, of course, the total income of that 
community. An inventory of rent and wages would show 
what quota was contributed to this total by human beings, 
land, and other instruments. It would be simply a list of 
the incomes from all these. By far the larger part is con- 
tributed by human beings. Professor Nicholson of Edin- 
burgh has estimated that in England the income earned by 
what he calls " the living capital " of Great Britain is five 
times as great as that earned by the " dead capital." In 
less wealthy countries the preponderance of man-produced 
income is probably still larger. Of the part produced by 
" dead capital " the larger portion is from land. A state- 
ment of the parts of total income due to various agents, 
such as laborers, land, and other capital which together 
yield that income, indicates the distribution of income rel- 
atively to the capital which produces it. 

It should be noted that though each of the various laborers 
and instruments of capital (land and other instruments) 
which jointly produce income, is credited with a certain 
part, it could not produce this part alone, or by itself. The 
earnings of a railway are due, for instance, to the joint work 
of the locomotive, cars, roadbed, terminals, and employees. 
These are not independent, but mutually complementary, 
instruments, and their services are complementary services. 
We impute to each a certain part, determined according to 
the principles which regulate the prices of complementary 
goods. 

In a new country the rent of land is apt to be low,but rent 
of other things and wages high. For in such a country land 
is abundant, but other forms of capital, including laborers, 
relatively scarce. As a country grows older and more 
populous, land becomes scarce relatively to population, or, 
in other words, the demand for land increases without any 



426 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

increase in supply. Therefore land rent tends to rise, and 
other rents and wages to fall. 

Progress in scientific knowledge causing an increase in 
productivity of land is like the rejuvenation of a country. 
Any increase in general productivities, whether of land or of 
other agents of production, has a tendency to make the rate of 
wages increase. For (i) byincreasing the wealth of employers 
and thereby diminishing the marginal desirability of money, 
there is a tendency to increase their demand for everything, 
including the services of workmen ; and (2) so far as work- 
men themselves are owners of houses, implements, and other 
instruments of any kind, and thus share in the increased 
affluence, the supply of work they offer is decreased, as we 
have seen. 

Such a result is probably the chief general effect of so- 
called labor-saving machinery. It increases the income of 
other classes than laborers, and with it their power to buy 
work of laborers. The first effect, however, is for the labor- 
saving machine to displace laborers, with which, in fact, 
they are competing articles, and we have seen that the in- 
crease in one of two competing articles or substitutes tends to 
lower the price of the other. The individual laborers thus 
displaced are likely to be injured by the improvement, 
being unable to learn another trade without undue loss of 
time. It is even conceivable that labor-saving machinery 
might become so automatic and so fully a substitute for 
human work that there would be no need and no demand 
for such work. But such an effect seems very improbable. 
The human machine is so much more versatile than other 
machines that its relation as substitute for labor-saving 
machines is not so important as its complementary relation 
to them. As a matter of history, so-called labor-saving 
machinery, while it " saves " or displaces laborers from one 
sort of work, often, if not usually, produces new needs for 
them in another sort of work. If horses and carriages were 
introduced into China, they would largely dispense with the 



Sec. 7] INCOME FROM LABOR 427 

need of coolies, who now carry passengers in sedan chairs, 
but they would call for coachmen and grooms. When, in 
turn, stagecoaches give place to railways, the trade of drivers 
of stagecoaches becomes obsolete, but the new trades of 
locomotive engineers, firemen, conductors, and brakemen 
are created. In fact, the very names of these occupations, 
as of hundreds of others, show that the demand for these 
kinds of work arises from the existence of machinery. In 
other words, while labor-saving machinery is always, as 
its name implies, a competing article with the human 
machine with respect to some of its many-sided capacities, 
it is usually also a complementary article with respect to some 
other capacity ; and we have seen that an increase in the 
quantity of one of two complementary articles tends to 
increase the price of the other. 

We have seen that an increase in the products of labor 
tends to increase the rate of wages. But while a general in- 
crease in the incomes enjoyed by a community usually tends 
to increase the rate of wages, an increased inequality of in- 
comes may have the reverse effect. At any rate, a decrease 
in the amount of capital which laborers own will, as we 
have already seen, make them willing to take lower wages 
than otherwise. In fact, the chief reason that there exists 
a wage class is that those constituting it have little or no 
capital apart from their own persons. Wage earners are 
chiefly " property less " persons — persons who have either 
never had any property, or have lost what they did have, 
as, for instance, through too high a " rate of impatience." 
We see, therefore, that the question of wages depends, 
among other things, on the distribution of the ownership 
of wealth. This will be the subject of the next chapter. 



CHAPTER XXV 

WEALTH AND POVERTY 

§ i. The Problems of Wealth and Poverty 

The first half of our study of quantities has related to 
the distribution of income relatively to the agents or instru- 
ments which produce that income. In the present chapter 
we shall take up the second half of the study of quantities 
— i.e., the distribution of this same income relatively to 
those who own and enjoy it. The two sorts of distribu- 
tion are quite different, although there has been a tendency 
to confuse them. This was natural, for in the early days 
of economics people were classified roughly according to 
the sort of instruments they owned. There was the land- 
lord class, whose chief income was ground rent ; the non- 
landed capitalist, whose chief income was from other 
capital than land; and the laborer, whose chief income 
was wages. It was then natural to imagine that the in- 
comes produced by laborers, by land, and by other capital, 
were also the incomes enjoyed by laborers, by landlords, and 
by other capitalists. But even were such a classification 
possible and duly made, it would still fail to tell us anything 
whatever as to how large was the per capita share within 
each class, or whether the amounts enjoyed by different 
individuals were or were not very unequal. The best we 
could say would be that certain land yields a rent of $10 
an acre, and other lands more or less than this ; that certain 
houses rent for $1000 a year, and others for more or less ; 

428 



Sec. i] WEALTH AND POVERTY 429 

that money lenders make five per cent on their loans ; and 
that ordinary wage earners get $2 a day. But these data, 
however detailed, would not tell us the relative income en- 
joyed by different persons, except in the case of the laborer, 
and then only on the assumption that he derived no income 
from any other source than from his work. Furthermore, 
to-day there are only small traces left of the old social strati- 
fication, and correspondingly little excuse for confusing the 
distribution of income with reference to the capital which 
yields it and its distribution with reference to the persons 
who own it. 

But, though the two sorts of distribution are distinct, 
each is needed to understand the other. The two preceding 
chapters were devoted to the first sort of distribution, and 
have prepared us for the study of the second sort. 

The problem now before us — distribution relatively to 
owners — may be described as the problem of the total 
income, the average income, and the relative numbers of 
people owning incomes of various sizes. The last-named 
part of the problem is the problem of grading the population 
according to income — the problem of discriminating the 
relatively rich and the relatively poor. No other problem in 
economics has so great a human interest as this, and yet 
scarcely any other problem has received so little scientific 
study. 

Since income necessarily comes from capital or from 
labor, the problem of " distribution " of income is largely that 
of the " distribution " of capital. Our problem may there- 
fore be stated either as the problem of the personal distri- 
bution of income or that of the personal distribution of 
capital and of labor-power. More simply it is the problem 
of " the distribution of wealth." 

For the purpose of comparing the wealth of different 
persons or nations, values are more important than quan- 
tities. If we know that A's income is worth $1000 a 
year and B's, $10,000, we may say that B's income is ten 



430 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

times A's in the sense that the elements composing B's 
income are worth in exchange ten times the elements com- 
posing A's income ; or, if we know that X is " worth " 
(i.e., owns capital worth) $1,000,000 and that Y is " worth " 
$10,000,000, we may say in like sense that Y's capital is 
tenfold X's. 

In order to compare the incomes or capitals of widely 
distant times or places, a correction may need to be made 
for differences in the purchasing power of money, and if the 
rate of interest is also different in the two cases, this cor- 
rection will not necessarily be the same for the capital as 
for the income. A millionaire worth $1,000,000 in Cali- 
fornia half a century ago, the rate of interest being twelve 
per cent, commanded an income equivalent to that of a 
multimillionaire to-day, worth $3,000,000 ; for the present 
rate of interest is only one third as high. Another point of 
difference between comparisons of capital-value and com- 
parisons of income- value lies in the fact that while capital- 
values differ only in size, income- values differ also in time- 
shape and certainty. For this reason a man rich in lands 
from which there is little immediate income — but only 
prospects of income in the distant future — is sometimes 
called " land poor," having much land, but little immediate 
income. 

But when, instead of comparing the wealth of different 
persons or nations, we are seeking to compare the absolute 
comforts they enjoy, it is more important to consider quan- 
tities than values. In fact, as noted at the outset of our 
study, money valuations are apt to be misleading. A 
country where water is scarce will put a higher money 
valuation on its water supply than a country where water 
is so abundant as to have no price. Thus, a large quantity 
of water shows more affluence in the sense of comfort than 
does a large value of water. 

Practically, however, if we confine our attention to 
modern times and conditions in western Europe and 



Sec. 2] WEALTH AND POVERTY 43 1 

America, it is true, in a general way, that of two nations or 
individuals the one which is richer in capital-goods is richer 
also in capital-value, in income-goods and in income-values. 
For simplicity we shall hereafter assume that these four 
comparisons are thus similar. We may say that a man is 
" rich " if he has a large amount of capital-goods of various 
kinds — lands, houses, stocks, bonds, etc. ; or a large 
money-value of capital-goods ; or a large amount of benefits 
of various kinds — nourishment, clothing, shelter, amuse- 
ments, etc. ; or a large money-value of benefits of these 
kinds. 

A man is " poor " if he has small amounts of all these 
things. 

Of course, the two terms " rich " and " poor" are purely 
relative, and represent no deeper scientific meaning. A man 
who is rich according to one standard may be poor accord- 
ing to another. But the two terms are very convenient to 
designate relative conditions. Corresponding to the ad- 
jectives "rich" and "poor" are the nouns " wealth " 
and " poverty " ; for, as noted in the first chapter, the term 
" wealth " is especially used to indicate a large amount of 
wealth just as the term " poverty " is used to indicate a 
small amount. Our subject, then, in this chapter is com- 
parative wealth and poverty, both of nations and of 
individuals. 

§ 2. National Wealth or Poverty 

We may divide this subject into two heads: the 
wealth or poverty of nations and the wealth or poverty 
of individuals. First as to the wealth or poverty of 
nations. 

" The wealth of nations " depends upon two things : 
their labor and their capital, including their lands and 
the other capital the people have produced. The income 
earned by the labor of a nation always far exceeds the 



432 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

income earned by all its capital. Yet people do not earn 
income without at least land. Given laborers and land, 
we have the only two real requisites of producing income. 
Other capital springs from these two. It is sometimes said 
that labor is the father, land the mother, and the other kinds 
of capital the children. A nation, then, is the richer, the 
larger the number of its inhabitants, the greater the extent 
of its territory, and the greater the amount of its accumulated 
products. 

These three groups or classes of capital depend each on 
somewhat different conditions. The amount of land and 
its power to produce is largely a question of natural re- 
sources. It may be taken as a given quantity presented to 
man by nature. It is now becoming recognized, however, 
that land is not so definitely constant in its power to pro- 
duce as was once imagined. One of the most important 
results of the recent " conservation movement " in this 
country is to show conclusively that land is not altogether 
a constant source of income, but that it is possible by the 
impoverishing and washing away of top soil greatly to im- 
pair or destroy absolutely the productivity of land ; while, 
on the contrary, by proper fertilization, keeping land fallow, 
rotation of crops, etc., it is possible to increase the efficiency 
of land just as it is possible to increase the efficiency of 
other instruments. 

The dominion over land by any given group of men 
may depend on wresting it by military force from another 
group. In fact, one of the chief objects of war has been to 
increase national wealth by adding to territory. This was 
a chief object of the Roman Empire and of the colonial 
system of Great Britain. These and other nations have 
had what is called " earth hunger." The wealth of the 
British Empire to-day lies for the most part outside of the 
British Isles ; for it includes, besides England, a number of 
important colonies — Canada, India, Australia, and parts 
of Africa. Except for the war of the Revolution, the 



Sec. 3] WEALTH AND POVERTY 433 

British Empire would now include also the territory occu- 
pied by the United States. 

Turning from the quantity of land or the " natural 
resources " of a nation to the number of inhabitants, 
we note that this itself depends in turn upon the extent 
of the territory as also on the past history of the nation 
and on other conditions which will be considered later 
in this chapter. Many nations have sought to increase 
their wealth and power by increasing their population. 
In fact, a chief reason for extending a nation's ter- 
ritory has been to fill it with colonists. A country is 
usually alarmed at the prospect of a stationary or decreas- 
ing population. France is now trying to conserve its 
population, recognizing that national strength for future 
wars or for future political position among the nations of 
the earth depends largely on the numbers of fighters and 
of workers. The productiveness of these people, as well as 
the productiveness of the lands they keep, will depend 
largely upon their condition as to vitality and accumulated 
knowledge. 

We come last to the amount of accumulated products. 
This depends on two chief qualities : first, thrift, which, as 
we have seen, leads to savings ; and, secondly, inventive- 
ness, which has led to the creation of income-producing 
instruments. 

§ 3. Per Capita Wealth or Poverty 

So much for the conditions determining the wealth of 
nations. We may pass now to the more important subject 
of the wealth or poverty of individuals. This subject may 
be divided into two parts : the study of average or per 
capita wealth, and the study of its distribution or the rela- 
tive wealth and poverty among different individuals. By 
the per capita wealth of any nation is meant the quotient 
found by dividing the total national wealth by the number 



434 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

of inhabitants. It is evident that two nations may compare 
very differently as to aggregate and as to per capita wealth. 
The small countries, Holland and Switzerland, when com- 
pared with the large countries, India and China, are far 
poorer in aggregate wealth, but far richer in per capita 
wealth. The per capita wealth in any nation will thus 
increase with an increase in the total wealth and decrease 
with an increase in population. 

With the advent of democracy in politics has come a 
greater emphasis on per capita as compared with aggregate 
wealth. Under autocracies the aim was to increase the 
wealth of the nation as a whole, partly for the personal 
aggrandizement of the autocrat or potentate, who often re- 
garded himself as a sort of owner of the nation (" Vetat, 
c'est moi "), and partly because the sentiment of national 
greatness was satisfied in this way. Under these conditions 
an increase in population was almost invariably welcomed 
and encouraged. But since the individuals of the nation 
have become its rulers and, so to speak, shareholders, they 
have regarded increase of numbers with mixed feelings ; for 
while on the one hand they welcome an increase in the 
total wealth which a greater population brings, on the 
other hand they do not relish a decrease in the per capita 
wealth which may ensue. In the democratic ideal, there- 
fore, an increase of population is usually welcomed only in a 
new country where there is plenty of land, or in a country 
acquiring colonies to provide room for a surplus population. 

The effect of an increase of national wealth on per capita 
wealth will evidently depend upon the ratio between land 
and population. In a sparsely settled country an increase 
of population will not only increase the aggregate, but also 
the per capita wealth ; for each new worker adds to the effi- 
ciency of workers already on the ground. A very few men 
cannot work together to as great advantage as a moderate 
number. The cooperation and division of labor incident 
to a moderate increase in population more than outweigh 



Sec. 3] WEALTH AND POVERTY 435 

the fact that the greater population will require more 
nourishment, clothing, and other items of income. In short, 
though there be more mouths to feed, each additional 
mouth means an additional pair of hands ; and the added 
capacity of the new hands to produce exceeds the added 
capacity of the new mouths to consume. The history of 
new countries shows that an increase in population is a 
blessing individually and collectively. 

When, how r ever, the country is settled and filled up with 
population to a certain point, the opposite becomes true, 
and a fresh increase of population, while continuing to in- 
crease aggregate wealth, will decrease per capita wealth. 
It then happens that each new pair of hands adds less to 
production than each new mouth subtracts in consump- 
tion. This fact sets a sort of elastic limit to an increase of 
population. That there must be such a limit is evident, 
since an indefinite number of people cannot be supported 
on one acre of land. We know as a generalization from 
ordinary observation that the billion and a half people 
now living on this planet could not be supported if all were 
packed into the state of Rhode Island and dependent on 
Rhode Island for sustenance. Per capita poverty would 
then be so intense that people would die of actual starva- 
tion. Famine, with the plagues which usually follow it, 
would decimate the population. Overpopulation in India 
and China often results in famine and plague. But in 
western civilization much milder instances of insufficiency 
of food are found. Long before such a starvation point is 
reached, every increase of population beyond a certain point 
results in an increased death rate. In fact, statistics show 
that the death rate increases as per capita wealth decreases. 
This fact is due to the unsanitary conditions which poverty 
necessarily brings ; conditions which pertain not so much 
to the quantity of food as to its quality and to the quantity 
and quality of housing and other comforts and conveniences 
of life — and perhaps above all to conditions of employ- 



436 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

merit, especially hours of labor. These unsanitary condi- 
tions incident to poverty result in fatigue, malnutrition, 
infection, diseases such as tuberculosis, and deaths. We 
have, then, ample evidence that when the ratio of popula- 
tion to land becomes excessive, the death rate is increased, 
and consequently a further increase of population is injurious 
to the individual. 

This law of per capita wealth is chiefly based on the 
anterior fact that land is an essential agent in production, 
and that each successive increase in the productivity of 
land is acquired at increasingly great cost — or, expressed 
otherwise, that, with each successive increase in cost, the 
return diminishes. This is the law of diminishing returns 
in agriculture. There is, then, based on facts, a general 
law of per capita wealth in relation to population. It may 
be stated as follows : Given a particular stage of knowledge 
and of the arts and of other conditions that determine 
productivity, an increase of population up to a certain 
point increases the per capita wealth, after which a further 
increase of population decreases the per capita wealth. 

§ 4. Population in Relation to Wealth 

The population of any country may be increased either 
by births or immigration and decreased either by deaths or 
emigration. The population of the world, as a whole, can be 
increased only by births and decreased by deaths. As we 
are more interested in general than in local increases or 
decreases in population, we may overlook the questions of 
emigration and immigration, assuming for the area under 
consideration that they are either absent or balance each 
other. 

With this proviso, we may say that population will 
decrease if the death rate exceeds the birth rate, and 
will increase if the birth rate exceeds the death rate. As 
we have already stated, the facts show that the death 



Sec. 4] WEALTH AND POVERTY 437 

rate increases with a decrease in per capita wealth. The 
birth rate remains to be considered. When Malthus, 
the first economist to make a careful study of population, 
wrote his famous " Principle of Population," it was in 
general true that an increase in per capita wealth produced 
an increase in the birthrate. To-day, however, this is true 
only to a certain extent. We shall for the moment, how- 
ever, consider only those cases where it is true. Under 
these conditions we may say that an increase in per cap- 
ita wealth tends to increase the birth rate and to decrease 
the death rate, and that a decrease in per capita wealth 
tends to increase the death rate and to decrease the birth 
rate. 

If we assume what history has almost invariably shown 
to be the fact, that in a sparsely settled country the birth 
rate exceeds the death rate, so that the population tends at 
first to increase, we are now in a position to state what will 
happen to the population of that country in future genera- 
tions, quite apart from any increase in immigration. By 
hypothesis the population will increase at first and, as at 
first each increase in population brings an increase in per 
capita wealth, it will continue to increase as long as this 
condition continues. But, as we have seen, it will ultimately 
happen that per capita wealth will cease to increase and will 
begin to diminish. It will then happen that the death 
rate will increase and the birth rate decrease, so that the 
increase of population will be slackened and ultimately 
cease altogether. Under these conditions, then, population 
in a new country will increase up to a certain point at which 
it will cease to increase. The population is then in a sort of 
equilibrium, the birth rate equaling the death rate because 
the per capita wealth has been reduced to such a point as 
to bring this equilibrium about. 

The law of population, therefore, may be stated as fol- 
lows : Assuming that in a sparsely settled country the 
population will at first increase, and knowing that as the 



438 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

per capita wealth decreases the death rate will increase, and 
the birth rate decrease, and therefore that the rate of in- 
crease of population will slacken and ultimately terminate, 
we have an increase of population followed by stationary 
population, the stationary point representing an equality 
between the birth rate and death rate, because people are 
either unable or unwilling to lower the standard of sub- 
sistence they have reached. 

This limit on human population is the same limit which 
nature sets on animal and plant population. Blades of 
grass multiply until they cover the ground on which they 
grow. When grass is sown on a grass plot, it multiplies 
with great rapidity, but after the whole plot is covered and 
there is no room for more, the number of blades remains 
nearly stationary. There is a struggle for life constantly 
going on, and the death rate thus produced is great enough 
to balance the birth rate which the capacity of the soil 
allows. Out of this struggle for existence among animals 
and plants comes what Darwin calls natural " selection," 
and it is interesting to know that Darwin's first idea of such 
a struggle came from reading Malthus on Population. 
Population is then said to be limited by the means of sub- 
sistence. 

Since Malthus's day there has come into more definite 
operation what he called the " voluntary check " on popu- 
lation. While it is still true that among tJie poor it usually 
happens that an increase in per capita wealth tends to 
increase the birth rate by encouraging marriages or making 
them earlier or increasing the number of children per mar- 
riage, it has become unfortunately true that among the 
wealthier classes an increase in wealth tends sometimes in 
the opposite direction. Instead of wealth being then 
thought of as a means of supporting children, it comes to 
be thought of as a means for gaining or for maintaining 
" social position," and the more wealth gained, the more 
ambitious are its possessors that its enjoyment may not be 



Sec. 4] WEALTH AND POVERTY 439 

interfered with by childbearing, or that it shall not be de- 
creased by subdivision in the next generation. The result 
is that the wealthier classes often have, on the average, 
smaller families than the poorer classes. We must, there- 
fore, modify the law of population so as to read that an 
increase in per capita wealth, instead of tending always to 
increase the birth rate, tends first to increase it and then 
to decrease it. This wealth check to population is peculiar. 
It is quite different from the poverty check. The poverty 
check works automatically so as to check population when 
it is too large and not to check it when it is too small. But 
the wealth check acts in the opposite way — or rather it 
would do so if it were sufficiently strong and general, which 
is not yet the case. Then it would come about that the 
greater the per capita wealth, the more would population 
be checked, and as the check to population usually tends 
to increase per capita wealth, this would still further de- 
crease population. The logical result is depopulation or 
" race suicide." 

At present, however, this wealth check is confined to cer- 
tain parts of the population, and results, for those parts 
only, in " race suicide." These parts include particularly 
the so-called " better classes " of the population. Statis- 
tics show that the children of college graduates are less 
numerous than the graduates themselves. Thus, besides 
depopulation, there is another danger, degeneration. If 
the vitality or vital capital is impaired by a breeding of 
the worst and a cessation of the breeding of the best, no 
greater calamity could be imagined. But while the risk of 
such a result undoubtedly exists, this is not immediate, and 
an increasing realization of its possibility, we may hope, will 
lead to some way of counteracting it. A method of at- 
taining the contrary result — namely, reproducing from 
the best and suppressing reproduction from the worst — 
has been suggested by the late Sir Francis Galton of Eng- 
land, under the name of " eugenics." 



440 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XXV 

§ s. Distribution of Wealth 

Having considered aggregate and per capita wealth, we 
come finally to the distribution of wealth among different 
individuals. Although a whole nation may be rich or poor 
relatively to another nation, the widest differences between 
nations are small as compared with the differences within 
any one nation. Every nation has its extremely poor, its 
extremely rich, and its classes in intermediate states. In 
the United States there are many wage earners who can- 
not earn $ia day, and who have no income except what they 
earn by labor, while at the opposite extreme are the multi- 
millionaires who receive incomes of over $1,000,000 a month. 

What are the reasons for such prodigious inequalities in 
the personal distribution of wealth? Are such inequalities 
injurious? If so, are they preventable? If so, by what 
means? These are some of the most burning questions of 
the day. Out of them spring many reform movements, 
and especially socialism. But these, like other practical 
problems, are applications of economic principles, and 
cannot be discussed in a book designed to treat only of 
economic principles themselves. Suffice it to say that no 
proper answer can be made to the last question of how to 
cure the unequal distribution of wealth until we have an- 
swered the first question of what causes this unequal dis- 
tribution. As often happens,, more study has already 
been devoted to cure than to diagnosis, and with the usual 
ineffective result of quack remedies. 

Our present object will be to set forth the causes which 
affect the relative personal distribution of wealth. What- 
ever these causes may be, they are evidently fundamental 
and universal; for we find that extremes of poverty and 
riches have existed at all times and places. They are men- 
tioned in the Bible and other histories of peoples in all ages 
and stages of civilization. It is probable that the degree 
of inequality differs as between the Oriental civilizations, 



Sec. 6] WEALTH AND POVERTY 44 1 

like China and India, on the one hand, and the Occidental, 
like England and France, on the other, and also as between 
the older nations of western civilization, like Russia and 
Italy, and the younger, like the United States and Canada. 
But the fact and the causes are each nearly the same every- 
where. Distribution differs in some degree, it is true, ac- 
cording to political institutions, as, for instance, between 
Germany and England. There is a comparative absence 
of extreme poverty in Germany as contrasted with Eng- 
land and the United States ; a comparative prevalence of 
poverty in Russia and Italy ; and a comparative frequency 
of extreme opulence in Holland. Nevertheless, Professor 
Pareto, a Swiss economist, has found that, as between dif- 
ferent countries for which statistics are available, and as 
between various periods of time, the statistical inequal- 
ities in the distribution of wealth have maintained a re- 
markable correspondence, more close, in fact, than statistics 
of mortality. 

The causes which have produced the present inequalities 
of wealth are largely historical; that is, they lie in the 
past. It usually takes more than one generation to affect 
greatly the economic standing of a family. For this reason 
some people have foolishly imagined that if to-day we could 
once correct the inequalities in wealth handed down to us 
from the past, the problem would be solved, and with a 
new and even start we would be forever rid of great poverty 
by the side of great wealth. We shall soon see, however, 
that if wealth were once equally divided, it would not stay 
so. The analysis of what would happen will serve as the 
best introduction to our study of distribution. 

§ 6. Equality of Distribution an Unstable Condition 

Let us suppose that, through some communistic or social- 
istic law, the wealth in the United States were divided with 
substantial equality. It is proposed to show that this 



442 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

equality could not long endure. Differences in thrift alone 
would reestablish inequality. We cannot suppose that 
human nature could be so changed and become so uniform 
that society would not still be divided into " spenders " and 
" savers" ; much less can we suppose that different people 
would all spend or all save in exactly the same degree. So 
long as there are any differences whatever between people 
in regard to their " rates of impatience " under like con- 
ditions, there will immediately ensue differences in saving 
or spending. It requires only a very small degree of sav- 
ing or spending to lead to comparative wealth or poverty, 
even in one generation. It is remarkable how much may 
be saved in a lifetime by thrift. Cases are sometimes 
found of day laborers who, by saving and putting at in- 
terest, accumulate within a lifetime a small fortune, and 
in the meantime rear a family. As Micawber said, a man 
with an income of one pound a week will reach poverty if 
he spends just one penny more, and reach opulence if he 
spends just one penny less. 

The larger the amounts saved or spent, the more rapidly 
is a fortune gained or lost. As we have seen, the process 
by which individuals thus gain or lose fortunes by saving 
or spending consists, in the last analysis, of an exchange 
of present and future income. If two men have to start 
with the same income of $1000 a year, but one has a rate 
of impatience above the market rate of interest and the 
other has a rate below, the first will continue to get rid of 
future income for the sake of its equivalent in immediate 
income, and the other to do exactly the opposite. Such 
substitutions of immediate for remote, and of remote for 
immediate, income may take place by means of loans, sales, 
or changed uses of capital. The man with spendthrift tend- 
encies will borrow, i.e., pledge future income for the sake of 
present income; or he will sell any durable goods which 
offer remote income, such as farms or forests, and buy 
perishable goods which offer immediate income, such as 



Sec. 6] WEALTH AND POVERTY 443 

champagne, clothing, horses, and carriages; or he will 
change the uses to which he puts his capital, avoiding those 
which require improvements, and choosing instead those on 
which he can realize quickly, thus letting his property- 
run down. 

The man with saving tendencies, on the other hand, will 
lend or invest present income for the sake of future, will 
sell perishable and buy durable goods, and will make far- 
sighted uses of his capital. Both men will pursue their 
respective policies up to the point where their marginal 
rates of impatience harmonize with the rate of interest. 

As we have seen, the rates of impatience among different 
individuals are equalized in these ways. In the case of an 
individual whose impatience to secure immediate income is 
unduly high, we found that generally he contrives in some 
way to modify his income-stream by increasing it in the 
present at the expense of the future. We were then intent 
on studying this phenomenon only on the side of income; 
but the effect on capital can be easily seen by applying the 
principles of Chapter VII. If a modification of the income- 
stream is such as to make the present rate of realized income 
exceed the "standard" rate, capital is being depleted to 
the extent of the excess, and the person will grow poorer. 
Individuals of the type of Rip Van Winkle, if in possession 
of land and other durable instruments, will sell or mortgage 
them in order to secure the means for obtaining enjoyable 
services more rapidly. The effect will be, for society as a 
whole, that these individuals who have an abnormally low 
appreciation of the future and its needs will gradually part 
with the more durable instruments, and that these will 
tend to gravitate into the hands of those who have the 
opposite trait. 

The central role is thus played by the rates of preference 
for present over future income and the rate of interest. 
The existence of a general market rate of interest to which 
each man adjusts his rate of preference supplies an easy 



444 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

highway for the change in his capital in one direction or 
the other. If an individual has spendthrift tendencies, 
their indulgence is facilitated by access to a loan market ; 
and reversely, if he desires to save, he may do so the more 
easily if there is a market for savings. The irregularities in 
the distribution of capital are thus due in part to the oppor- 
tunity to effect exchanges in the parts of the income-stream 
located at different times. The rate of interest is simply 
the market price for such exchanges. By means of this 
market price, both those who wish to barter present for 
future income and those who wish to do the reverse may 
satisfy their desires. The former will gradually increase, 
and the latter gradually diminish, their capital. If all in- 
dividuals were hermits, it would be much more difficult 
either to accumulate or to dissipate fortunes, and the dis- 
tribution of wealth would therefore be much more even. 
Inequality arises largely from the exchange of income, car- 
rying some individuals toward wealth and others toward 
poverty. In short, the inequality of wealth is facilitated 
by the existence of a loan market. In a sense, then, it is 
true, as the socialist maintains, that inequality is due to 
social arrangements; but the arrangements to which it is 
due are not, as he assumes, primarily such as take away 
the opportunity to rise in the economic scale. On the con- 
trary, they are arrangements which facilitate both rising 
and falling, according to the choice of the individual. The 
improvident sink like lead to the bottom, while the provi- 
dent rise to the top. 

But thrift, important as it is, is not the only road to 
wealth, nor thriftlessness the only road to poverty. Besides 
differences in the rates of impatience, there are equally 
potent differences in ability, industry, luck, and fraud. 
By ability is meant one's capacity to earn, by industry the 
use of this capacity. Examples of getting rich from ability 
and industry are very common. Almost all the rich men 
in this country who have made their fortunes have done so, 



Sec. 6] WEALTH AND POVERTY 445 

in part at least, through ability and industry. Often luck 
has aided greatly. There are many examples of miners 
who got rich in Colorado by simply stumbling on a 
gold mine. Luck plays a larger role in the accumulation 
of fortunes than many are inclined to believe. The " un- 
earned increment " is usually a case of luck. Unforeseen 
increase in ground rents has given rise to large fortunes 
from time immemorial. It is also unfortunately true that 
some men have really got their start, if not their larger 
accumulations, through fraud. This has sometimes oc- 
curred through " high finance," which consists very largely 
in making contracts with one's self at the expense of others 
whose interests he, as director, trustee, etc., happens to 
control. If a man is a director in a corporation, and votes 
to have it buy materials of himself at any price he sets, he 
naturally can become rapidly wealthy at the expense of the 
stockholders. Also through political " graft," and especially 
through getting city franchises for gas and waterworks and 
street car companies, and through special tariff legislation, 
many men have become wealthy. Poverty, on the other 
hand, has often resulted not only from thriftlessness, but 
from incompetence, i.e., lack of ability, slothfulness (lack of 
industry), and misfortune or bad luck, and from having 
been defrauded by others. 

We conclude, therefore, that equality of wealth is an un- 
stable condition and, even if once established, would not 
endure, because of unequal forces of thrift, ability, industry, 
luck, and fraud. 

But inequality once established tends, by inheritance, to 
perpetuate itself in future generations. The workman who 
accumulates a few thousand dollars from nothing makes it 
easier for his children to accumulate more. He gives them 
a start or a " nest egg." Recently four sons of a Con- 
necticut farmer met in a family reunion. Many years pre- 
viously the father had sent them into the world to make 
their fortune, giving each $700 to start with. When they 



446 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

met at the recent family reunion, all were worth thousands. 
The well-known woman millionaire, Mrs. Hetty Green, 
is an example of a person who inherited a large fortune 
and then accumulated, by her low " rate of impatience," 
i.e., her preference to accumulate for the future rather 
than to spend in the present. A fortune of $6,000,000 
was bequeathed her, and now her fortune is reputed to be 
worth $100,000,000. 

Likewise poverty may be passed down from generation to 
generation. A special cause for handing down inequality 
of fortunes lies in the reduction of the birth rate among 
the rich. As we have explained, the tendency to-day is 
for the poor to have a high birth rate, and for the rich to 
have a low birth rate. There results a tendency toward an 
increase in the numbers of the poor and a decrease in the 
numbers of the rich. This result tends to exaggerate the 
differences in the per capita wealth between the two classes, 
for in the upper classes there will be an increasingly larger 
share for the few who inherit fortunes, and in the lower 
classes there will be an increasingly smaller share for the 
many. 

We see, then, that there is at least a tendency for the 
rich to grow richer and the poor to grow poorer. We may 
even go so far as to say that the richer a man or family 
becomes, the easier it is to grow richer, and that the poorer 
a family becomes, the more difficult it is to keep from 
growing poorer. Large fortunes often grow without effort. 
All that is necessary is for their owners to refrain from 
squandering. On the other hand, a family once caught in 
poverty is apt to be drawn deeper into the mire. Overwork, 
anxiety, and unsanitary surroundings bring on disease or 
disability, which robs them of what little they once had. 
The opportunity of the wealthy is their wealth, and the 
curse of the poor is their poverty. " To him that hath 
shall be given, and from him that hath not shall be taken 
away even that which he hath." 



Skc. 7] WEALTH AND POVERTY 447 

§ 7. The Limits of Enrichment and Impoverishment 

Yet there are limits to enrichment and impoverishment. 
The ordinary downward limit is reached when a man loses 
all his capital. He has then no source of income left except 
his own labor. When a man has succeeded in losing all 
his capital, the process usually comes to an end, because 
society, in self-protection, decrees that it shall go no farther. 
He is in most civilized lands not allowed to sell in advance 
much of his distant future services. But where there is 
no such safeguard, the unfortunate victims may sink into 
even lower stages, such as the debt servitude in the Malay 
Archipelago or Russia, and to some extent in Ireland ; or 
they may even sell themselves or their families into slavery. 
In most countries the poor come to be a large and per- 
manent as well as a helpless class. 

Next, as to the upper limit. We have seen that the op- 
portunity to increase one's wealth depends upon the market 
for present and future goods, i.e., the loan and investment 
market. A hermit cannot become immensely wealthy ; nor 
can any of the inhabitants of a small island, if cut off from 
the rest of the world. The utmost that a man in an isolated 
community can own is the capital which that community has 
or can get — its land, dwellings, means of locomotion and of 
manufacture, etc. These are necessarily limited by the size 
of the community. As the market widens, the limits to 
the growth of large fortunes widen also. To-day there is 
no limit to what one man may accumulate except that he 
cannot more than " own the earth." 

This relationship between the possible size of individual 
fortunes and the size of the market to which the owner of 
the fortunes has access is important. Practically it means 
that in these modern times, when almost the whole world is 
one great market, the possibilities of individual fortunes are 
greater than ever before. Few people realize this fact ; for 
most people imagine that at any time in the world's history 



448 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XXV 

any fortune could have increased at compound interest. 
But a fortune is capital- value, and, as we have seen, capital- 
value has no power to produce income, but, on the contrary, 
is merely the discounted value of anticipated income. The 
only way a man's fortune can increase at compound interest 
is by his constantly reinvesting income as it comes in ; that 
is, exchanging it for other and later income at the discounted 
values of the latter. But evidently he must find sellers of 
some such other and later income before he can buy it, and 
he must find purchasers of the income which he would fain 
sell. His income has no power whatever of itself to create 
other income. In short, an extreme upper limit to the 
growth of any individual fortune is set by the scarcity of 
income-producing instruments available. 

The common idea that " money has power to breed 
money " leads to absurdity when applied to compound 
interest. Were it true, any person might leave fortunes to 
posterity far exceeding the possible wealth which this 
earth can hold. The prodigious figures which result from 
reckoning compound interest always surprise those who 
make the computation for the first time. One dollar put at 
compound interest at four per cent would amount in one 
century to $50, in a second century to $2500, in a third 
century to $125,000, in a fourth century to $6,000,000, in 
a fifth century to $300,000,000, in a sixth century to 15 
billions, in a seventh century to 750 billions, in an eighth 
century to 40 trillions, in a ninth to 2 quadrillions, and jn a 
thousand years to 100 quadrillion dollars. Now the total 
capital in the United States is only about 100 billions, and 
that in the world at large — even assuming that the per 
capita wealth elsewhere is as large as the United States, 
which is an absurdly large allowance — must be less than 
2 trillions, which is only one fifty-thousandth part of what 
we have just calculated as the amount at compound interest 
of $1 in 1000 years. Yet 1000 years is only half the time 
since the Christian era began. In 2000 years the $1 would 



Sec. 7] WEALTH AND POVERTY 449 

amount to 100 quadrillion times 100 quadrillions, which is 
many, many times as much as a world composed of solid 
gold. Needless to say, such a prodigious increase of wealth 
could never actually take place, for the simple reason that 
this is a finite world. The difficulty lies, not simply in the 
reluctance of people to provide for accumulation several 
centuries after their death, but also to the fact above 
mentioned, that large accumulations would reduce oppor- 
tunities for reinvestment and therefore reduce the rate of 
interest. The attempt, for instance, to invest trillions 
every year would drive up the prices of all investable prop- 
erty, i.e., all capital. To invest such sums would practically 
require the purchase by the rich man of all existing railways, 
steamships, factories, lands, dwellings, etc. But many of 
the present owners of these, having already sold a good 
deal and thus reduced their rates of impatience to equality 
with the prevailing rate of interest, would not part with 
more except at prices so high that the purchaser would 
make little or no profit or interest on his investment. Thus, 
the approach toward the limit of investment would reduce 
the rate of interest and retard, and finally altogether prevent, 
further accumulation. 

There are some interesting examples of long-continued 
reinvestments. Benjamin Franklin at his death, in 1790, 
left £1000 to the town of Boston and the same sum to 
Philadelphia, with the provisos that they should accumu- 
late for a hundred years, at the end of which time he calcu- 
lated that at five per cent each legacy would amount to 
£131,000. In the case of the Boston gift, it actually 
amounted, at the end of the century, to $400,000, and has 
since accumulated to about $600,000. The sum received by 
the city of Philadelphia has not increased so fast. 

Another interesting case of accumulation is that of the 
Lowell Institute in Boston, which was founded in 1838 by 
a bequest of $200,000, with the condition that ten per cent 
of the income from it should be reinvested and added to the 

2G 



450 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

principal every year. A peculiarity of this provision is that 
it applies in perpetuity. There is, therefore, theoretically, 
no limit to the future accumulation thus made possible, 
and it would be interesting to know what will be its 
history in future centuries. The fund, after only 67 years, 
amounted to $1,100,000. 

§ 8. The Cycle of Wealth 

With a world market for investment, we have every pros- 
pect of a great increase in private fortunes in the next few 
centuries. But practically the limit reached in the history 
of most large fortunes is only a very small part of the high 
limit we have set, that of " owning the earth." There is 
usually a reaction against the desire to accumulate. Each 
reduction in the rate of interest tends to check the desire 
to accumulate. Moreover, this desire soon palls. A 
multimillionaire recently left his fortune to accumulate 
until 21 years after the death of his youngest heir, with the 
intention of accumulating by that time the largest fortune 
on record. But his heirs much preferred to use it during 
their own lifetime, and succeeded in breaking the will. 
Even had they not succeeded, those who finally came into 
the fortune would probably have begun, at least in a few 
generations, to dissipate it; for the usual effect of great 
wealth is to produce habits of spending. 

It has already been noted that one's rate of impatience 
for future income, given a certain prospective income-stream, 
will be high or low according to one's past habits. If a 
man has been accustomed to simple and inexpensive ways, 
he finds it fairly easy to save and ultimately to accumulate 
a considerable amount of property. These habits of thrift, 
being transmitted to the next generation, result in still 
further accumulation, until, in the case of some of the de- 
scendants, affluence or great wealth may result. But if a 
man has been brought up in the lap of luxury, he may have a 



Sec. 8] WEALTH AND POVERTY 45 1 

keener desire for present enjoyment than if he had been ac- 
customed to the simple living of the poor. The effect of 
this factor is that the children of the rich, who have been 
accustomed to luxurious living, and who have inherited 
only a fraction of their parents' means, and often lack their 
ability and business training, will, in attempting to keep up 
the former pace, be compelled to check the accumulation 
and even to start the opposite process of the dissipation of 
their family fortune. It requires a certain amount of ability 
merely to maintain a fortune. Bad investments carelessly 
entered into are often the means of impairing or even anni- 
hilating a fortune. And then the unfavorable effects of 
luxury begin. A few years ago there came to this coun- 
try an English physician who had inherited a large fortune, 
but who had also inherited the desire to indulge himself in 
the present to the full extent of his capacity. To defeat the 
effects of this desire, his parents had left him only the in- 
come of their wealth " in trust " (and it is not an unusual 
thing in England, where there are spendthrift sons, to leave 
property so that they may use only the income). Never- 
theless, this man contrived, by chattel mortgages and in 
other ways, to spend a good deal more than the interest 
annually accruing, and he was always in debt and in trouble. 
The product of such a course is, sooner or later, what is 
called a " shabby genteel " class. Eventually people in 
this class will have to overcome their pride, go to work, 
and become laborers — and often common laborers. After 
a few generations of poverty and the illiteracy which goes 
with it, the wealth-holding ancestry is forgotten. It is said 
that examples of such ancestry are common among laboring 
men, and would be more generally recognized were it not 
for the loss of records which is the inevitable accompani- 
ment of illiterate poverty. 

Thus the limits set by scarcity of investments to the pos- 
sible growth of large fortunes are always far higher than 
the vast majority of fortunes ever approach. Most for- 



452 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XXV 

tunes rise and then fall, the turning point being due to the 
abandonment of thrift and the substitution of thriftlessness 
which the fortune itself sooner or later engenders. An old 
adage has put this observation in the form, " From shirt 
sleeves to shirt sleeves in four generations." We have no 
inheritors to-day of the fortune of Croesus, who, in his day, 
was supposed to be a wealthier man than Rockefeller, not 
only in proportion to the wealth of his time, but absolutely. 
A man with a start of that kind ought to have been able to 
make the fortune increase rather than decrease with the 
future, and yet we know of no heirs to that fortune. To-day 
we have a large number of wealthy families in this country, 
but most of them are only one generation old! Thus the 
very rich families, so far from growing rich indefinitely, 
usually do not even continue rich more than a few gener- 
ations, but grow poor, arriving, too, at that condition 
without the vitality or the character necessary to retrieve 
themselves. 

Likewise, at the opposite extreme, it does not always 
happen that the poor grow poorer or even remain poor. Just 
as wealth often relaxes thrift, poverty sometimes stimu- 
lates thrift. The children of the poor then become fired 
with ambition to get on in the world simply because they 
are poor. These people rise from the ranks, and rise rap- 
idly. It should be noted, however, that unlike the down- 
ward movement of large fortunes, this upward movement 
is the exception, not the rule. It may be that ninety per 
cent of large fortunes reach a maximum and decline, but 
it is doubtful if one or two per cent of the poor reach a 
minimum and rise. Many fall into pauperism or die. The 
vast majority simply remain poor. We see, then, that 
while it is very easy for those who have once reached the 
top of the economic strata to stay at the top, this result 
seldom occurs, chiefly because of their conversion from 
savers to spenders ; and while reversely it is very easy for 
those who once reach the bottom to stay at the bottom, 



Sec. 9I WEALTH AND POVERTY 453 

they do not always do so, chiefly because of their conver- 
sion from spenders to savers. 

§ 9. The Actual State of Distribution 

The churning up of society resulting from saving and 
spending and the other causes above mentioned neutralizes 
the tendency we have mentioned for the rich to grow richer 
and the poor to grow poorer, and, what is more important, 
it prevents — to some extent — the establishment of wealth- 
castes by continually changing the personnel of wealth and 
poverty. The individuals of society are like goldfish in an 
aquarium. Those once started upward continue to ascend 
for a time, whereupon they start down again. Those once 
started downward continue to descend until perhaps they 
reach the bottom, whereupon they (may) start up again. 
To complete the figure, we must suppose the shape of the 
aquarium to be like a bell, very small at the top and very 
large at the bottom. There is room for only a few at the 
top, and the struggle of many to get there makes it difficult 
for any, while it makes it easy for all to descend. There is 
most room at the bottom, and consequently there is less 
change there than anywhere else. Reversely, at the top 
there is most change. The constant changing of position in 
this bell jar, while of great moment to the individual, does 
not greatly affect the distribution of society as a whole. 
There will always be about the same proportion of fish at 
each successive stratum. Professor Pareto has, in fact, 
represented the distribution of wealth by a bell-shaped 
figure which he calls the social pyramid. This is shown in 
Figure 48. The number of people having an income be- 
tween Oa and Ob is represented by the contents of the bell- 
shaped vessel between the plane of a a" and the plane of 
b'b" . The social pyramid represents the fact that the 
larger the size of a fortune, the smaller the number of people 
who have it. There are many more at the bottom than at 



454 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

the top. We have no exact statistics for this country, 
but a rough popular estimate states that over half of our 
population have incomes of less than $600 per year, and of 
the remaining half about half (i.e., one fourth of the whole 
population) enjoy incomes between $600 and $1200, and 
the other half (i.e., the remaining fourth of the whole popu- 
lation) have incomes over $1200. 




§ 10. The Problem of Wills 

The frequency of changes in fortunes, whether up or down, 
will differ greatly in different countries according to the 
ages of the countries, and their laws and customs. Among 
these factors the laws and customs as to the inheritance of 
wealth are of great importance. If there is an equal distribu- 
tion among the children of the rich, the fortune is pretty 
sure to run itself out in a few generations or centuries ; but 
in England this result is prevented by giving to the oldest 
son the bulk of the estate and cutting everybody else off 
with small stipends. The effect of this custom is to main- 
tain the family dignity and the integrity of the large estate. 
In this country there are signs that we are gradually chang- 



Sec. io] WEALTH AND POVERTY 455 

ing toward this English custom by which a rich man, instead 
of dividing his fortune evenly, leaves the bulk of it to one 
of his heirs. Such a change in testamentary custom will 
furnish a new and powerful tendency for existing inequal- 
ities to be accentuated and perpetuated. 

One of the special problems connected with inheritance 
is that of the control over wealth a man should be allowed 
to exercise after he has died. This problem has frequently 
been under discussion. It is sometimes called the problem 
of " the dead hand." Out of this problem grew the " statutes 
of mortmain " ; and also the common law rule that no testa- 
tor can " tie up " his estate beyond " lives in being " at the 
time of his death plus 21 years. This common law rule ap- 
plies, however, only to so-called " private " bequests. To 
escape its operation a rich man very often leaves his fortune 
to some " charitable " foundation. But as it is ill advised to 
leave a fortune in the hands of private persons for a number 
of generations, so it has been found ill advised to leave for- 
tunes in perpetuity in any shape whatever. For the result 
is that after a few generations it is impossible to carry out 
the instructions of the donor without doing harm — how- 
ever good his intentions. Conditions will have come about 
which the donor could not foresee or provide for. In Nor- 
wich, England, for instance, there was left many generations 
ago a small sum to support a preacher for the Walloons, who 
should utter a sermon in Low Dutch every year at a certain 
time. That provision is still carried out, although there are 
no longer any Low Dutch in this place. There is no one to 
understand the sermon, and yet it is preached every year. 
Recently the preacher has learned one sermon by heart and 
repeats it every year in order to receive his remuneration. 

In 1862 a lady died in England and left a fortune to be 
used for the teaching of the doctrines of Joanna Southgate. 
This person had had a large religious following in England, 
but at this time, 1862, there was not a single soul in Eng- 
land who believed in her doctrines. Here was the curious 



456 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

spectacle, therefore, of a fortune being left in the hands of 
trustees, no one of whom could be found who believed in 
these doctrines. In 1587 a certain man died leaving to 
the almshouse of Suffolk certain real estate, the income 
of which was then £113. The income at present is £3600, 
far more than the institution can use, and the trustees do 
not know what to do with it. The result has been to make 
the almshouse a mecca for all poor people for miles around 
and to pauperize the neighborhood. 

The custom of making wills is one that is handed down 
to us from the Roman days. Regarding wills, there were 
no laws in ancient Germany, no provisions in the Levitical 
laws of the Jews, none among the Hindus, and only slight 
traces among the ancient Greeks. When we talk of the 
sacredness of private property and the right to dispose of 
it by will, we are merely expressing our loyalty to the 
particular custom under which we now happen to live. 

It may be that in the future a remedy for some of the 
present evils connected with the ownership of wealth may 
be found by limiting or regulating the inheritance of wealth 
as to time or amount, by inheritance taxes, by limiting 
private ownership in certain perpetuities, by substituting 
leaseholds for perpetual franchises or for "fee simples" in 
mineral lands, or even in all lands. There is much to be said 
on both sides of these proposals, but it is no part of our pres- 
ent task to enter upon their discussion. 



CHAPTER XXVI 

WEALTH AND WELFARE 

§ i. True and Market Worth 

An often-quoted passage from the Bible states that 
" the love of money is the root of all evil." Another states 
that "it is easier for a camel to go through the needle's eye 
than for a rich man to enter into the kingdom of heaven." 
On the other hand, poverty has always been regarded as 
an evil. Agur prayed that he should be given neither 
riches nor poverty. This is the theory of the golden mean. 
Still another view is that while, absolutely, wealth is good 
and the more of it per capita the better, yet its unequal 
distribution is an evil. This is the view of the socialists. 

In all these views there is some truth. Extreme wealth 
and extreme poverty are alike evils, and the disparity be- 
tween the extremes is also an evil. Moreover, besides these 
evils dependent on the quantities of wealth are other evils 
dependent on the qualities of wealth. But how can it be 
that wealth, which is merely the physical means for satis- 
fying human wants, can ever do harm? We have escaped 
this question hitherto because we have accepted wealth, 
so to speak, at its market valuation. As was explained at 
the outset, prices are determined by the actual desires of 
men, and, when seeking to explain prices as they are, we 
were not obliged to inquire as to whether the desires which 
explain them are foolish or wise, good or bad. There was 
no need to distinguish between the desires which fix the 

457 



458 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

prices of Bibles and those which fix the prices of obscene 
literature. Now, however, we propose to go a little deeper 
and to point out instances in which desirability is not in- 
trinsic utility, and in general to point out the various ways 
in which market valuations fail to give a true picture of 
actual worth. As we have seen, market valuations of for- 
tunes do not even show their comparative desirabilities, 
because of the wide differences between the marginal de- 
sirabilities of money to different people. The marginal 
desirability of money decreases rapidly with an increase of 
wealth, so that — beyond a comfortable competence — the 
addition of millions means little that is really desirable. 
In fact, to some men like Mr. Carnegie, swollen fortunes 
become a burden and responsibility rather than an addition 
to personal gratification. 

§ 2. Evils Connected with the Quantity of Wealth 

That extreme poverty is an evil needs no proof. We 
shall, therefore, not discuss the problem of poverty. The 
chief causes of poverty we have already shown, and its 
remedies lie beyond the scope of our discussion. Suffice it 
to say that the problem is the greatest of all practical 
economic problems and is justly claiming a large share of 
the attention of philanthropists and reformers. Among 
the remedies or partial remedies suggested are socialism, 
old-age pensions, compulsory workmen's insurance, regu- 
lation of hours of labor, better housing, abolition of disease, 
education in thrift, profit-sharing, cooperation, monopo- 
lization and regulation of labor by trade unions. 

At the opposite extreme lie the opposite dangers and 
evils ..of great wealth. If the poor are too hard working, 
the rich are too idle. If the poor are underfed, the rich are 
overfed. If the poor have the discomforts of squalor and 
shabbiness, the rich have the discomforts of excessive atten- 
tion to personal appearance. If the poor suffer from 



Sec. 2] WEALTH AND WELFARE 459 

overcrowding, the rich suffer from the burden of overgrown 
establishments. If the poor drink alcoholics to get rid of 
fatigue, the rich drink them to get rid of ennui. 

Not only does each extreme have its evils and dangers, 
but the unequal distribution of wealth has evils and dangers 
of its own. One of these is the perverted use of great 
wealth in a manner to humiliate, degrade, or demoralize the 
poor. Unequal distribution of wealth produces a caste feel- 
ing, breeding contempt for the poor by the rich, and envy 
of the rich by the poor. Corresponding to differences in 
wealth grow up differences in the mode of living, education, 
language, and manners, differences which distinguish the 
" gentleman " and " lady " from the common herd, and 
which gradually become confused with innate differences, 
which are quite another matter. Aristocracies are almost 
always founded on wealth and are therefore almost always 
on a false basis. There are undoubtedly wide differences 
between men. If so-called aristocrats were really all the 
name would imply, the " best " in body, mind, and heart, 
much could be said in favor of their segregation from the 
" vulgar " crowd, and the development from them of a 
better race of men. But a plutocratic aristocracy is based, 
not on what men are in themselves, but on what they possess 
outside of themselves. 

Because of the differences in wealth, the poor serve the 
rich. The relation of master and servant is not simply a 
commercial relation. It also represents a supposed differ- 
ence in caste. 

Probably the worst demoralization of the poor, growing 
out of inequalities of wealth, is the prostitution of the 
daughters of the poor for the sons of the rich. All students 
of prostitution are agreed that it rests on this economic 
basis. For the white-slave traffic most people are blaming 
those who engage in it, just as for drunkenness most people 
blame the saloon keeper. Doubtless these agents have 
their share of moral responsibility. Yet they are merely 



460 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

the brokers in the business. The demand and supply are 
the important factors, and the demand and supply arise 
chiefly because of the unequal distribution of wealth. 

Next to the poor selling their souls comes selling their 
votes. Bribery and political corruption are largely due to 
differences in wealth. In a democracy we have the ideal 
conditions for such perverted uses of wealth. In a democ- 
racy there are two great powers, the power of the ballot 
and the power of the purse. The power of the ballot rests 
with the poor because of their numbers. The power of 
the purse rests with the rich. Nothing could be more nat- 
ural than that the unscrupulous representatives of these 
two powers should contrive to get together for mutual 
advantage. They need not meet directly. The perverted 
politician intervenes as a broker. Many of the city govern- 
ments of the United States exemplify this condition. These 
politicians make, on the one side, a business of controlling 
the votes of the poor, partly by bribery, partly by dispens- 
ing " charity," and partly by activity in party organiza- 
tions; and, on the other side, they make a business of 
" holding up " the capitalists who want franchises for street 
railways, water, gas, electric light, or telegraph or special 
tariff legislation. The unscrupulous capitalist finds it ad- 
vantageous to pay toll to the politician, either by actual 
bribery or by stock in corporations, or by what a politician 
recently called " honest graft " in the form of " tips " or in- 
side information as to the stock market, real estate transac- 
tions, etc. Some of the politicians in our state legislatures 
and even in our national Congress are of this character. 
Some are avowed or secret representatives of capital or 
"the interests"; others, of voters or "the people." In this 
case the conflict between plutocracy and democracy becomes 
more direct and visible. But it always exists and will 
continue to exist, in some form, unless one of the two 
powers shall some day completely vanquish the other. 



Sec. 3I WEALTH AND WELFARE 46 1 

§ 3. Forms of Wealth Injurious to the Owner 

We have seen several of the evils, and in particular some 
of the misuses, to which wealth may be put. We can better 
understand the nature of these and other misuses if we 
reemphasize the fact that wealth, as we have denned it, 
does not include the most precious of our possessions, our- 
selves. The evils of wealth consist largely in an increase of 
external wealth at the sacrifice of what may be called, meta- 
phorically, internal wealth. Emerson said : " Health is the 
first wealth." The founder of Christianity asked, " What 
shall it profit a man if he shall gain the whole world and 
lose his own soul?" Many a millionaire would willingly 
give all his millions for youth, health, or even freedom from 
pain. Many uses of external wealth practically injure our 
internal wealth. The injury may be physical or moral or 
both. It is in this regard especially that " satisfactions," 
in the economic sense, fail to measure real welfare. Indeed, 
as regards the body, we may classify satisfactions into self- 
benefiting and self -injurious. Many articles of wealth, 
though possessing commercial value, are really injurious 
to those who use them. In some cases the articles of 
wealth referred to are used almost exclusively by the rich, 
in others, almost exclusively by the poor. Among examples 
of self-injurious satisfactions or uses of wealth are the con- 
sumption of unwholesome food or the wearing of constrict- 
ing clothing or the use of dwellings injurious to the health ; 
the practice of unhygienic or immoral amusements, the use 
of narcotics, such as opium in China, hashish in India, 
absinthe in France, whisky in Ireland, and alcoholic bev- 
erages in western civilization generally. These may be 
called perverted uses of wealth, but they are very common, 
so common as to give commercial value in millions of dol- 
lars to disease-producing food factories, distilleries, saloons, 
dives, gambling houses, low dance halls, and theaters, 
houses of prostitution, immoral and degrading literature. 



462 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

The perverted satisfactions here represented are capital- 
ized like any other satisfaction. They are often paraded 
to show how wealthy a nation is, but as they weaken 
the stamina of the people and shorten their lives, they 
really lessen the satisfactions in the end. In any com- 
plete view of the subject they should be recognized as 
sources of national weakness, not strength. This is recog- 
nized in the great reform movements — housing reform, 
temperance reform, and the movement to abolish the 
" white-slave " traffic. 

§ 4. Forms of Wealth Injurious to Society 

Other evils of wealth consist in its use by one person to 
injure another. Just as we classified some satisfactions into 
personally beneficial and injurious, so other satisfactions 
may be classified into socially beneficial and injurious. 
Examples of socially injurious satisfactions are of many 
kinds. Robbery, fraud, embezzlement, arson, and other 
criminal acts are too obvious to need more than mention. 
A burglar's " jimmy " is an article of wealth to the burglar, 
but it nevertheless is a means of injury to society. 

Of less obvious examples one is the exploitation of gold 
mines when their product depreciates the currency. As we 
have seen, the production of gold at a sufficiently rapid rate 
tends to raise prices. Here we find great gold fields, stamp 
mills, assay and smelting works, etc., standing in our ac- 
counts as important items of national capital. Yet, when 
they produce fluctuations and uncertainty in our monetary 
standard, they are injurious, rather than beneficial, to the 
country. While they afford means and opportunities for 
their individual owners and exploiters to make great private 
fortunes, they do not enrich a nation or the world ; for their 
sole effect is merely to change the numbers in which prices are 
expressed. Thus, much of the labor and capital invested 
in gold mines may be said to be socially wasted. A small 



Sec. 5] WEALTH AND WELFARE 463 

amount of money is as good a medium of exchange as a 
large amount ; while if gold flows out of the gold mines 
fast enough to raise prices, the result is social harm rather 
than good, disturbing the distribution of wealth and con- 
tinually tending to precipitate a crisis. 

The gold miner's fortune is thus often made, not by an 
addition to the world's real wealth, but by an abstraction 
from the world's wealth for his benefit, with secondary 
effects more or less injurious. When it happens that gold 
can be profitably mined far in excess of the needs of new 
money to maintain a constant price level, the gold miner 
is, as it were, robbing society. Thus, even the most gen- 
uine gold brick, as to which there is no thought or intent 
to defraud, may prove in the end an unconscious swindle. 

Other examples of socially injurious wealth are such nui- 
sances as the " smoke nuisance," privy vaults in a city, and 
" pests " of various kinds. A factory which defiles the 
household linen and the lungs of the neighborhood is not 
an unmixed benefit. If all the injury it caused could accrue 
to the factory owner, he would put in a smoke consumer, or 
else most willingly suffer a great deduction in the value of 
his plant. Instead, he causes a great loss of value thinly 
distributed over blackened houses and an injury never cap- 
italized or measured in the health of his fellow citizens. 
Such cases, where social interests and individual interests 
do not run parallel, justify legal interference. We cannot 
allow bonfires or bad sanitation in a crowded city merely 
because many individuals want the " freedom " to have 
them, nor freedom of movement on the part of those car- 
rying infectious diseases. 

§ 5. Forms of Wealth used for Social Rivalry 

The other examples of socially injurious uses of wealth 
we shall mention are all cases of social rivalry or racing. 
Three special cases will be considered. 



464 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

The first relates to warfare and the preparation for war. 
It is usually conceded that actual warfare is economically 
injurious. The best that the apologists for war can say 
is that it is inevitable. But it is not so well recognized 
that the economic preparation for war is an example of 
world waste, albeit an effort toward economy on the part of 
each individual nation. When Germany invested millions in 
armaments, she merely stimulated France to do the same. 
The two nations have been racing with each other ever 
since, as have other countries, including England and the 
United States. Each battleship which costs $10,000,000 in 
the end adds practically nothing to the world's productive 
capital. On the contrary, as soon as a similar battleship is 
added to the navies of rival powers, the various nations are 
in precisely the same relative position as before any battle- 
ships were built at all. Preparation for war is a species of 
cutthroat competition. If six world powers, instead of in- 
vesting each $10,000,000 in a battleship, should agree not to 
do so, the result would be to save $60,000,000 from being 
wasted. The case would be very different if the ships be- 
longed to the merchant marine. In that case, the building 
of $60,000,000 worth of ships would add that much to the 
world's productive capital. The utility of merchant ships 
is absolute, that of battleships is relative. The only object 
in one nation's building a battleship is to increase its 
strength relatively to other nations. Just as soon as this 
move is met by the other nations, all the advantage which 
it was sought to gain is lost again. 

Thus, for the most part, the " capital " of nations, in the 
form of armaments, represents economic waste, although 
no one nation could afford to dispense with it as long as 
other nations do not. 

Our second example of socially injurious rivalry is com- 
mercial cutthroat competition. We have seen that what is 
often to the interests of individual producers is against the 
common interests of producers as a group. We may now 



Sec. 5] WEALTH AND WELFARE 465 

add that it may be injurious to the interests of society as a 
whole. In fact, we have already noted that a patent and 
copyright have their justification in the fact that the play 
of unprotected individual interests would practically re- 
sult in discouraging or suppressing inventions and books. 
The same must often be true in other instances. Tele- 
phone competition is not only injurious to the telephone 
companies but to each subscriber, who either has to have 
two or more telephones in his house, with all the expense 
and annoyance which that arrangement implies, or has to 
remain in want of proper and easy connection with sub- 
scribers to other systems than the one he happens to employ. 
Our third example of socially injurious rivalry is perhaps 
the most important and pervasive, although the most 
subtle of all. It concerns rivalry in wealth itself, and 
introduces us to the subjects of luxury, extravagance, social 
ambition, and vanity. Thackeray's novel, " Vanity Fair," 
is a satire on the sort of economic rivalry referred to. 
Vanity may be denned as a desire to obtain the ap- 
proval of others, and vanity leads to social rivalry. This 
may be considered as rather a broad definition of vanity, 
and it is one which does not always or necessarily imply 
any slur. The important part played by vanity in eco- 
nomic affairs is seldom realized. A case of pure vanity 
is seen when a man wants merely the badges of distinc- 
tion. For instance, the badge of the Legion of Honor 
which Napoleon established in France is much desired, 
merely as a means of obtaining the approval of other 
people. It has no intrinsic desirability. It is not be- 
cause it is beautiful that it is desired ; it is not because 
the badge can keep one warm or appease one's hunger or 
fulfill any of the primitive and individual desires of men. 
It merely appeals to the instinct to attain distinction in the 
eyes of other people. Most cases of vanity, however, are not 
so pure, but are mixed with a substratum of actual utility. 
For instance, a diamond is desired chiefly out of motives of 

2H 



466 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

vanity, but it is desired also because it appeals to the aes- 
thetic sense. It is a curious fact that as soon as we mix 
vanity with some other motive, people begin to hide behind 
this other motive and conceal the vanity of which, for some 
reason, they seem to be ashamed. When a woman wears 
a diamond hatpin, and can never, by virtue of its position, 
see it herself, what motive is there except vanity ? Of course 
it may be said that she is an altruist in attempting to pro- 
vide an article of beauty for other people to admire ; but 
the real object, however she may condone or conceal it, is 
to display this diamond to other people and to show thereby 
that she is in the fashion or leading it and able financially 
to do so. Most articles of ornament pander chiefly to this 
form of vanity and come into existence largely and chiefly 
for this reason, although the admiration of actual beauty is 
a secondary element and a subterfuge. 

The amusements of mankind are almost always, or to a 
large extent, mixed with the motive of vanity. For in- 
stance, automobiling to day is not always indulged in for 
the sake of sport alone, but also for the sake of display. 
Equipages have always been one of the means of displaying 
wealth. Narcotics have always been objects desired not 
merely for their drug effect, but also for the effect of display. 
The habit of using fine wines and expensive drinks in enter- 
taining has long been one of the methods of social display. 
Clothing, even, and housing, are very often objects of 
vanity. In fact, historically, clothing originated as orna- 
ments, like jewelry, rather than as an actual protection from 
the weather. Even food is a matter of vanity to a certain 
extent. Feasts have been favorite occasions for the exer- 
cise of this instinct. 

A few extreme examples of ostentation will help us to 
understand the nature of vanity. Some years ago there 
was an American in Florence who carried the idea of display 
in his equipage to the extreme of getting a chariot and 
having sixteen horses to pull him through the narrow streets 



Sec. 5] WEALTH AND WELFARE 467 

of the city. Ordinarily an attempt to gratify vanity re- 
sults in the approval which is sought by the individual, 
but in extreme cases like this it often results in disapproval, 
and this man was known in Florence for years as " that 
fool American." A well-known French count, who through 
marriage became possessed of means, gratified the instincts 
of vanity by proceeding to spend untold sums in building 
a large and useless colonnade of pillars, simply to show 
that he was able to do so. A person not long ago left a 
will providing $1,000,000 for the erection of his own tomb. 
Cleopatra once showed what she could afford by drinking 
a dissolved pearl. Pliny states that after Cleopatra did 
this she was imitated by the son of a famous actor, and 
the practice of drinking pearls became a sort of fashion 
in Rome, as to-day some men of a less subtle vanity light 
cigars with $5 bills. It was probably this practice which 
led to the phrase "money to burn." In Philadelphia not 
very long ago a lady had a carpet made with a special 
design, and when the carpet was completed she was care- 
ful to have the design destroyed lest any one else should 
have a carpet like hers. A well-known speculator is said to 
have bought for his wife for $30,000 a particular carnation, 
in order that it might be called by her name. In Holland, 
centuries ago, there was a furor over tulip bulbs which 
took such a hold on the people and led to such extrava- 
gantly high prices that in 1639 one bulb sold for what 
would be approximately $2000 in our money. 

Another instance is found in the admiration people have 
for foreign importations. Many people really delude 
themselves with the idea that they care for an imported 
cigar or wine because they believe the article to be superior 
to the domestic article. Nor is this the only species of 
vanity appeased by the purchase of foreign goods. An art 
dealer in San Francisco found that certain people preferred 
to pay $4000 in Paris for the same picture which they could 
buy in San Francisco for $2000, in order that they might 



468 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

state that they bought it in Paris. Some artists of San Fran- 
cisco found it advisable, therefore, to take their pictures to 
Paris, in order that they might get higher prices from 
Americans. California wines go to Europe to be returned 
as " imported " wines. Not long ago an American who 
lives in a well-known cheese-making district in New York 
paid a very high price for an imported cheese and took 
great delight in the fact that it was imported. As a mat- 
ter of fact, it had first been exported from his own town. 
New York cigars are shipped to Key West to be reshipped 
from there as " Key West " cigars. 

Jewelry has always been regarded as an object of vanity. 
If a chemical method should be developed of making a real 
diamond cheaply, the desirability of diamonds would be 
destroyed; they would immediately go out of fashion; 
the invention would be self-destructive, and the price of 
diamonds and the use of diamonds destroyed. That is, 
diamonds are desired because they are scarce and a badge 
of economic power of the people who purchase them. This 
is why imitation jewelry is regarded as a sham. Paste 
diamonds may be quite, or nearly, as beautiful as real 
diamonds, but they can never be so valuable. Those who 
use them do so not because they regard them as beau- 
tiful, but usually in order to make people believe they are 
" real " and that the possessor can afford to buy them. 
Sometimes they are worn as symbols of real diamonds kept 
for safety in bank vaults. The owners then appear at the 
opera with the imitation jewels. When spoken to of their 
jewels, these people will say that they are not real jewels, 
but are an exact imitation of real jewels which are in 
the safe deposit vaults. In such cases the imitation jewels 
serve purely and simply as badges of ownership. There is 
then supposed to be no pretense involved. The wearers 
would be thought " cheating " if they possessed only the 
paste. Their virtue consists in actually having the " real 
thing," which the paste replica proclaims. A wealthy 



Sec. 6] WEALTH AND WELFARE 469 

woman seriously argued the question of whether a poor 
woman had a right to wear an imitation diamond. Her 
thought was that, since the poor person could not afford 
to have a real diamond to wear, the imitation diamond 
amounted to deceit. 

§ 6. The Cost of Vanity 

Now the efforts to satisfy vanity are like international 
armaments. The chief advantage that social racing gives to 
an individual is a relative advantage. But this implies that 
he puts other people at a relative disadvantage. So far as 
society is concerned, the cost of keeping up the race is a total 
waste. This cost consists in the labor expended on the grati- 
fication of vanity, and shows itself in the high prices of articles 
for that purpose. The tax thus laid by society upon itself is 
enormous, and may be measured roughly by the annual pur- 
chases of articles of pure vanity. Yet people seldom com- 
plain, for the individual can see little or no difference between 
the good he gets from an article of vanity and the good he 
gets from any other article. He does not care much about 
the pace he may be setting for others, and he does not hold 
any other person responsible for the pace which has been set 
for him. He looks at the world's fashion as an inevitable 
fact, and adjusts his own actions to it. Our task, however, 
is to look at the social effects of his action on others, and of 
others' actions on him. His expenditures for vanity may 
give him the satisfaction of " climbing," but by as much as 
he gets ahead of others the others are left behind. They are 
all in a social race to get ahead. In the scramble all are at 
great effort or expense, and in the end there is a loss of eco- 
nomic power similar to the loss of nations racing for military 
supremacy. Undoubtedly the race stimulates the racers, 
and may do them some good as a mode of exercising their 
abilities, and even lead to useful inventions. The same 
maybe said of war. But our present purpose is to point out 



47° ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XXVI 

the cost, which is usually overlooked. If the true cost 
could be expressed in figures, it would doubtless amaze 
people who have never stopped to see the extent to which 
luxury and luxurious rivalry is carried. Almost all expendi- 
ture is more or less colored by it. 

We have called the extravagance which is created by the 
desire of a man to compete with his neighbor in vanity 
social racing. Now when fashion enters into the matter, 
as it almost always does, this race becomes more like a 
chase. There are leaders and followers, and the followers 
try always to overtake the leaders. When they do so, the 
leaders turn in their course in order to elude their pursuers. 
The consequence is that fashions are constantly changing 
at the hands of the leaders of fashion. The leaders of 
fashion are usually from among the richest people in the 
community, and whatever they consume, those beneath 
them in the social or economic scale wish to consume 
also. 

We may take, as an example, the case of russet shoes, 
which are constantly coming in and going out of fashion. 
A few years ago a gentleman was surprised to find that 
only the highest grades of russet shoes were carried on the 
market. When he asked the reason, he was told that russet 
shoes had gone out of fashion only a year or two before; 
that now they were coming in, and the only way by which 
they could be got in was by putting the highest grades on 
the market first, because if the lowest and cheapest grades 
were put on, then the leaders of fashion would not want 
them, and if the leaders did not want them, then followers 
would not want them either. Consequently the demand at 
the top is the one to be first supplied. After this initiatory 
demand has been satisfied, the shoes are imitated in cheaper 
grades, until finally russet shoes become so common that 
the leaders refuse to wear them longer and they go out of 
fashion — only to come back again in a few years, after which 
the same cycle is repeated. 



Sec. 7] WEALTH AND WELFARE 47 1 

Vanity is literally insatiable. Without vanity there 
would be little use for the fortunes of multimillionaires. 
Beyond a modest fortune more money would be to them 
entirely superfluous. Therefore the use to which they put 
their millions is of much more moment to society than to 
themselves. If they use it to set standards of luxury, they 
are using it in a socially injurious manner. They produce 
the same effect on society as though they levied a tax on 
all persons poorer than themselves. 

§ 7. Remedies for the Evils of Vanity 

We have seen that the natural remedy for cutthroat 
competition in business is combination. In the same way 
if there could be a general " disarmament," as it were, or 
agreement between the social competitors, it might solve 
the problem of social rivalry. 

This declaration of truce has, indeed, been put in opera- 
tion on a small scale in schools, colleges, and clubs. A 
good instance is to be found among women's sewing cir- 
cles. When such a circle is first organized, the hostess 
gives a very simple entertainment. At the next meeting 
a rival hostess gives something a little more elaborate, and 
presently the members of the circle are madly racing in 
the effort to supply the best entertainment. A reaction 
becomes necessary and the ladies finally agree explicitly 
" not to serve more than two kinds of cake." 

An example of how this general disarmament works was 
seen in San Francisco at the time of the earthquake. There 
the people who lived formerly on Nob Hill in fine houses 
had to live in tents or out of doors. So far as this loss was 
concerned, it was no loss at all — at any rate, no loss at 
first — because each man was perfectly willing and liked to 
live out of doors, provided his neighbor lived in the same 
way. Yet before the earthquake any one of these people 
would have been ashamed to live in a tent because he knew 



472 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

that his neighbor would wonder why he did not live in a 
house as good as his. 

Very similar to social disarmament is compulsion by the 
government. The Dutch government, for the sake of the 
nation's resources, finally took a hand in the tulip craze, and 
the traffic in bulbs was stopped. History contains many 
examples of sumptuary laws designed to check social racing. 

One cure was suggested by John Rae (a Scotch economist 
writing in 1834) which is ingenious, although it has never 
been consciously put into use. He says, and wisely, that 
we cannot change this inherent ambition in human nature. 
All we can do is to turn it to some good account instead of 
letting it run to waste. He suggested that social racing 
could be made to yield a revenue to a government by tax- 
ing imported luxuries so as to make them expensive, and 
therefore desired by the wealthy and out of the reach of 
their imitators. A case in point is that of the cheap wines 
of France being dear in England because of the tariff and 
cost of importation across the channel, and reversely, the 
cheap wines in England being dear in France. Each was 
fashionable in the country of the other, but unfashionable 
at home. Now if a tax is able to create a fashion in this 
way, through making an article exclusive, the government 
can get a revenue by creating a fashion, and the tax im- 
posed on society by fashion could thus be made to accrue 
to the government. 

Another way is to change the fashion of fashion, so to 
speak, so that it may be made to run in more useful channels. 
One of the better forms of vanity is that which does not sat- 
isfy itself by display in the usual sense, but seeks to make a 
record of power in the financial world. In these days a man 
may advertise his wealth in other ways than by high living. 
To be known as the largest stockholder in a railway is one 
of the coveted distinctions. Again, by publishing names 
and amounts contributed, the newspapers give distinction 
to the large contributors to charity. It is well known 



Sec. 7] WEALTH AND WELFARE 473 

that more money can usually be raised by a public sub- 
scription list than by a church collection, where the con- 
tributor obtains no public notice. The publicity of tax 
lists even stimulates a desire, though still weak it is true, 
to have one's name near the top of the tax list. Even 
display is taking on new and healthier forms. One wealthy 
American is distinguishing himself by buying works of art 
and loaning them to the great art galleries of Europe 
and America. In fact, in spite of many evidences to 
the contrary, there are some indications that display, in 
the old sense, is decreasing, especially among men. To- 
day men seldom wear jewelry or gaudy clothing. Busi- 
ness distinction takes the place of these. Even women 
are becoming ambitious to lead in other ways than 
in " society." They seek distinction in their women's clubs 
or as executives in charitable effort. There is, as a matter 
of fact, no reason why rich men and women should not try 
to distinguish themselves by doing good, and the tendency 
in America to-day is exactly in this line. Rich men are 
gradually trying to distinguish themselves by their large 
benefactions instead of by their large expenditures. They 
create great philanthropic foundations and endow hospitals, 
sanitaria, libraries, and universities. 

A few years ago, in the city of Pittsburg, two wealthy 
men vied with each other in erecting fine buildings for 
the good of the city of Pittsburg, and one, in order to tri- 
umph over the other, who had put up imposing buildings 
in a certain square, purchased the square immediately ad- 
jacent at a very exorbitant price for the purpose of erecting 
a still finer public building. 

Social racing of this sort may be socially beneficial and 
is an encouraging sign of the times. At present, however, 
great wealth is as a rule either running to waste or taxing 
those who cannot keep up with it. Perhaps some day it 
may — like other great wastes — be caught and harnessed 
and made to do some of the world's work. 



474 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

§ 8. Recapitulation 

We have now completed our brief review of the elementary 
principles of economics, or the study of wealth. It has fallen 
under three heads : (i) the " foundation stones," (2) the 
determination of prices, and (3) the principles of distribution. 
Under the first head were set forth the great concepts of 
the science, namely, wealth itself, the central theme, and the 
closely connected concepts of property, benefits and costs, 
price and value, capital and income. We saw how these 
concepts are defined, and, what is more important, how they 
are related to each other. In particular, we saw that prop- 
erty rights always have a basis in tangible wealth or persons ; 
that wealth is a means, and property a right, to future bene- 
fits and costs; and that those present valuations called 
" capital " are the net discounted values of future benefits 
called " income." These relations were found to be illus- 
trated by the principles of accounting. 

Our second task grew out of the first. The formal con- 
cepts and relations had furnished us tools of thought, but 
they had not explained the facts with which they dealt. 
They had shown us what prices and values are, but not how 
they are determined. The determination of prices thus be- 
came the focal point of study. We found the problem of 
price-determination to be twofold, — the problem of deter- 
mining price levels and the problem of determining individual 
prices. The former is the problem of the purchasing power 
of money, and depends, for its solution, on the study of the 
" equation of exchange." We found that the price level 
is normally proportional to the quantity of money, and in- 
versely proportional to the volume of trade; it was also 
noted that the volume of deposits subject to check (rela- 
tively to the money in circulation) and the velocities of cir- 
culation of money and of deposits are important factors in 
the problem, and that the disturbance of the normal condi- 
tion of the magnitudes in the equation of exchange has much 



Sec. 8] WEALTH AND WELFARE 475 

to do with periodical crises and depressions of trade. The 
other problem (individual prices) was again subdivided into 
two, the one relating to the prices of individual goods, and 
the other to the rate of interest. The key to the first was 
found in " marginal desirability," and that to the second, in 
" marginal impatience," or excess of the desirability of a 
present dollar over the desirability of a future dollar. 

Having seen the principles which rule the markets of the 
world, we were ready for our third and last task, — to study 
the larger results of these forces on the distribution of in- 
come, relatively to its sources and owners. This last topic 
led to a consideration of the effects of this ownership on 
social welfare. 

Throughout the book we have confined ourselves to the 
study of principles, — the principles by which capital and 
income are related, the principles by which prices are fixed, 
the principles by which wealth or poverty is produced, the 
principles by which men and women waste wealth in useless 
rivalry. The whole study has been, as a study of scientific 
principles should be, cold and impartial. The practical 
application of the principles was not included, and the stu- 
dent was warned at the outset against taking any partisan 
position on economic questions until he had some ground- 
ing in economic principles. Now, however, that he has 
studied these principles, he is strongly advised to continue 
the subject in other books devoted to practical applications. 
The chief use of a study of principles is as a preparation for 
the study of their application ; and, unless educated men 
use their knowledge of principles as a means of influencing 
public opinion on economic problems, the solution of these 
problems will be left to those who neither understand nor 
recognize the existence of any economic principles. Every 
educated man owes it to the community to use his education 
for intelligent leadership. To-day is a time of reform move- 
ments, and never before was there greater need of leadership 
in those movements. This book will not have fulfilled its 



476 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

function if it does not induce the readers to apply its prin- 
ciples to their own lives and to the life of the nation of which 
theirs is a part. Its chief object is to put them in a position 
to study and help solve the great problems of money, trusts, 
labor unions, workingmen's insurance, hours of labor, hous- 
ing and hygiene, and, above all, the problems of wealth and 
poverty. 



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